Capital, Accumulation, and Money Second Edition
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Lester D. Taylor
Capital, Accumulation, and Money An Integration of Capital, Growth, and Monetary Theory Second Edition
Lester D. Taylor University of Arizona Department of Economics Tucson, AZ 85721 USA
[email protected] ISBN 978-0-387-98168-0 e-ISBN 978-0-387-98169-7 DOI 10.1007/978-0-387-98169-7 Springer New York Dordrecht Heidelberg London Library of Congress Control Number: 2010936358 # Springer Science+Business Media, LLC 2010 All rights reserved. This work may not be translated or copied in whole or in part without the written permission of the publisher (Springer Science+Business Media, LLC, 233 Spring Street, New York, NY 10013, USA), except for brief excerpts in connection with reviews or scholarly analysis. Use in connection with any form of information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed is forbidden. The use in this publication of trade names, trademarks, service marks, and similar terms, even if they are not identified as such, is not to be taken as an expression of opinion as to whether or not they are subject to proprietary rights. Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com)
Dedicated to the memory of John P. Britton (1938–2010) and H.S. Houthakker (1924–2008), teacher, collaborator, and friend.
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Preface to First Edition
This book has been long in the making. About 25 years ago, I began spending a lot of time puzzling over what capital is and what is meant by capital theory. I read and read, but the more I read, the more confused I became. For a number of years, my hope was that the problem lay with me, that capital theory was a consistent whole, with a great deal of relevance to the real world, and that I was simply unable to grasp what it was all about. Eventually, it became evident that to search for a single concept of capital in the canon of economics was a will-o’-the-wisp and that the problem is not a single concept of capital, but a surfeit of concepts. There are physical capital, capital goods, financial capital, working capital, circulating capital, fixed capital, etc. When appearing without an adjective, and depending upon the writer, “capital” can refer to one, a subset, or all of the concepts at once. Vagueness and ambiguity concerning capital appear in the writings of all of the great capital theorists, whether Smith, Ricardo, Marx, Jevons, Walras, Bo¨hm-Bawerk, Clark, Wicksell, Schumpeter, Fisher, Hayek, Keynes, Hicks, Robinson, Samuelson, or Solow. When I finally came to understand this, it also became clear what to do: develop my own concept of capital and then proceed to theorize about it. The concept of myros is the result.1 Myros (or fluid capital, as it will eventually also be called) is the unifying concept of the book. The basic ideas underlying myros are introduced in the Prologue in the context of a subsistence, but otherwise idyllic, island economy
1
I have chosen the word myros because of its sonority (at least to my ears and mind) and because of its beguiling hint of a tranquil mythical isle in the Aegean. Its inspiration is clearly Greek, but as far as I am aware the word is “clean.” My friend, Phil Fleming, who is an expert on Classical Greek, tells me that there is no obvious Greek root for the word; however, my friend and colleague, Dick Newcomb, and also my consultant on Latin, says that there is a Latin root, murus (walls), from which myros might be seen as a transliteration. As I know nothing about Classical Greek and Latin, I rely on these experts’ judgment in support of my whim that myros is an appropriate word for the purpose I have in mind, which is to employ a word for capital that is not burdened by centuries of verbal and analytical baggage and connotations. Later, as the concept becomes understood, I will replace the word myros by a more conventional term, fluid capital. vii
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whose only good is bread that each person mines each day for his/her own use. The climate is benign, and inhabitants sleep under the stars. The bread is storable, but it had never occurred to anyone to store any until 1 day a young man decided that he wanted a roof over his head at night. However, as constructing a “house” was going to require time that could not be spent in the bread mine, the young man began (by working some extra hours each day in the mine) fashioning a stock of bread that would sustain him during his days of building a “house.” This stock of bread represents myros. Once the concept of myros comes to be understood, it will be seen that a conservation principle emerges which imposes a variety of constraints on the macro behavior of an economy. Indeed, this book, at its most basic level, is simply a working through of a number of implications of these constraints. The constraints make for a straightforward understanding and analysis of such concepts as the real stock of money, the general price level, and real-balance effects. Indeed, one of the principal conclusions of the book is that a real-balance effect in the aggregate cannot exist. New and illuminating insights are also provided into aggregate supply and demand, natural and money rates of interest, the relationship between real and monetary economies, inflation and deflation, and economic growth and development. The book has a number of recurring themes, three of which warrant mention here. The first of these is that money is endogenous in a monetary economy and is constantly in the process of being created and destructed. As will be noted at several points, a major failing of neoclassical theory is that it does not allow for a meaningful role for money. The concept of myros rectifies this. A second theme is that an economy cannot be treated (as is the case in canonical neoclassical theory) as though it were a nineteenth-century physical system. My views regarding the problems in doing this are presented in Appendix A. Finally, a third theme is an emphasis on fallacies of composition, of which the absence of a real-balance effect in the aggregate is a prime example. For the most part, the material in the book is presented non-mathematically. This is intentional for two reasons. In the first place, my concern in the book is primarily with the presentation and discussion of concepts and ideas. Only in a few instances are mathematics beyond arithmetic, algebra, and geometry needed to accomplish this. In the second place, to frame the arguments mathematically would compromise, at least at this stage, the view just stated that an economy cannot be analyzed as though it were a conservative energy system. The book is directed at several audiences. First – and foremost – it is intended for my fellow economists. Although the topics of the book are primarily macro, microeconomics is never far from the surface, and is center stage in Chaps. 5, 10, 12, and 13 and Appendix B. Among other things, I hope to challenge my brethren into considering whether twentieth-century capital and monetary theory may have taken some wrong turns, perhaps even to convince them that this has indeed been the case. If nothing else, I want to show young economists just beginning their research programs that capital theory, which has been largely dormant since the Cambridge Capital Controversy of the 1960s and 1970s, is still a fruitful and exciting area for research.
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A second intended audience is students. Graduate students should find the book useful because it presents a comprehensive view of macroeconomics and monetary theory in a way that is almost totally alien to present-day graduate macro courses. If my own department is any guide, current-day graduate macroeconomics is taught largely as an exercise in dynamic programming. Keynes may be referred to, but never read, and the same is true of Friedman, Hicks, Patinkin, and Tobin. And the thought of having students read Schumpeter never arises, even though The Theory of Economic Development is as fresh today as when it first appeared (in German) in 1911. And the same is true of the General Theory.2 Undergraduate students can also benefit from the book, although in most circumstances it will be necessary that they have help from a sympathetic teacher. Appendix D (now Appendix E), which greatly expands the material presented in the Prologue, and includes a number of questions and exercises, has been developed expressly with undergraduates in mind. In addition to Appendix D (now Appendix E), the relevant material for these readers will be the Prologue, Chap. 2, the first part of Chap. 3, and parts of Chaps. 12 and 13. A third intended audience is those who are regular readers, say, of The Wall Street Journal, The Economist, or Forbes. Although the reasoning connected with myros may, at first blush, seem subtle and arcane, it is less so (at least in my opinion) than the myths which lie behind most conventional uses of the words “capital” and “money.” “Investors” who are interested in financial markets should be able to acquire a better understanding of how financial markets are tied to the real economy, while those interested in macroeconomics and macroeconomic policy should be able to acquire a better understanding of how financial markets intertwine with the real economy. For this group of readers, the Prologue, Chaps. 2–7, and 12–13 are relevant. The book consists of the Prologue, 14 chapters, and four (now five) appendices. The Prologue begins with a number of stories describing the emergence from an economic state of nature of a primitive subsistence economy. The intent in these stories is to illustrate in a straightforward and natural way not only the concept of myros, but also the emergence of physical capital, money and a monetary system, loans and interest, inflation, and the creation of a variety of assets, including works of art. The Prologue is intended to be accessible to everyone, and is essential to an understanding of the book. Chapter 1 is mostly a personal memoir that lays out my approach to economics, economic theory, and model-building. Chapters 2–9 comprise the analytical core of the book. Formal definitions of myros and other key concepts are presented in Chap. 2, while Chap. 3 provides an overview of the macroeconomic framework. Money and interest are discussed in Chap.4, and production and investment in Chap. 5. Chapters 6 and 7 focus on the general price level and inflation, wealth, and related topics, while Chap. 8 is devoted to
2 For a number of years, my goal has been to read the General Theory annually. I don’t quite succeed in doing this, but I have probably read it 15 times or so. Each reading provides new insights and understanding. It is a truly amazing book.
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traditional questions relating to macroeconomic equilibrium. Finally, Chap. 9 places the concepts of this book in historical perspective with conventional concepts of capital found in the literature. Chapters 10–13 are mostly applications and examination of implications of the constraints associated with myros. Chapter 10 looks at some misperceptions concerning opportunity and sunk costs, while Chap. 11 discusses trade, exchange rates, and questions related to wealth transfers and monetary overhangs. Included in Chap. 11 is a detailed analysis of the wealth transfers associated with the reunification of Germany following the fall of the Berlin Wall in late 1989. Chapters12 and 13 focus on saving and consumption and economic growth. Finally, Chap. 14 provides a summary and conclusions. Appendix A is an essay detailing my views on the role of theory in economic analysis, including an argument as to why an economy cannot be analyzed as though it were a conservative energy system. This essay should be read in conjunction with Chap. 1. Appendix B is an exercise showing why investment functions do not necessarily slope downward, and should be read in conjunction with Chap.5. Appendix C examines the productivity implications of the oil price increases that occurred in the 1970s. This appendix, while intended to be stand-alone, involves the “transfer” questions treated in Chap. 11, and can be conveniently read in conjunction with that chapter. Finally, Appendix D (now Appendix E), as already noted, is expressly intended as a pedagogical exercise for students. During the many years that the ideas in this book have been incubating, I have benefited from discussions with a number of friends, colleagues, and students, not all of whom are economists, and certainly not all of whom are convinced that what I am doing is correct, or even useful. I am especially indebted to my (now) fellow Jackson Hole resident (and regular golf companion), Bruce Egan, for his encouragement and financial support (while he was at BELLCORE) when I was first developing the ideas on cost, production, and investment presented in Chaps. 5 and 10. Discussions on these topics with James Alleman of the University of Colorado in Boulder, Richard Emmerson of INDETC International in San Diego, Jim Griffin of Texas A&M, and Sandy Levin of Southern Illinois University in Edwardsville have been extremely helpful as well. Both Lester Thurow of M.I.T. and Dennis Weisman of Kansas State University have been willing readers of early drafts of the manuscript and sources of encouragement. The same is true of my colleague in Agricultural and Natural Resource Economics at the University of Arizona, Alan Ker, as well as a couple of anonymous reviewers. The two people who have made the most enduring contributions to the development of my ideas are my colleagues and friends at the University of Arizona, Barbara Sands and Richard Newcomb. Barbara, in her quest to understand the concept of myros, has challenged me at virtually every turn, pointing out errors and uncovering thin and specious reasoning. Any clarity that the manuscript may have is in great part due to her. In addition, for a number of years, she has championed the use of the “primitive economy” in her undergraduate classes, and Appendix D (now Appendix E, which was once the Prologue) is included at her suggestion.
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Interaction with Dick Newcomb has largely taken the form of a floating luncheon seminar that has occurred over the last 15 years, usually at the Arizona Inn (a few blocks east of the University of Arizona Medical School in Tucson). In the pleasant surroundings of the Inn, we have discussed the many subtleties of neoclassical capital theory, particularly as applied to mineral economics. Dick thinks in terms of Hamiltonians, and I admire the grace and good humor with which he has suffered through many attempts to convince me that this is the route that I should take. Of non-economists, I am especially indebted to Phil Fleming, logician, expert on the history of science and Classical Greek, and my longtime mentor in numismatics and things collectible. Phil, who has no formal economics background, once absorbed the gist of the concept of myros in an hour lunch and immediately picked up on the conservation principle that myros entails. My confidence in the ideas of this book soared as a result. I am also grateful to students in courses (both graduate and undergraduate) at the University of Arizona and CERGE-EI at Charles University in Prague, The Czech Republic, where I taught during the spring semester of 1996. Jason Shackit and Jean Abraham at the University of Arizona, and Miana Plesca and Georgi Kambourov at CERGE, warrant particular mention in this regard. Finally, on the production side, I am indebted to Patricia Lenoir, who typed the initial draft of the manuscript, and to Wendy Baylor, my neighbor on Heck of a Hill, who has formatted and produced the final copy. I am especially grateful to Wendy for being both a superb technician and an extremely perceptive reader and editor. If economics is a science, then, over long periods of time, its methods should guard against taking of wrong turns. However, I think that a wrong turn was taken in macroeconomics when the nascent ideas of Keynes of the General Theory were absorbed into mainstream economics in the neoclassical synthesis. In my view, the concept of capital that is developed in this book repoints macroeconomics in a more fruitful direction. Is my concept of capital necessarily the “correct” one? Of course not. Yet, the conservation laws implied by it seem too simple and natural for the idea not to have basic validity. In his defense of the General Theory, Keynes stated that he considered his basic ideas to be definitive, but that he could be wrong in the details. I feel the same about the concept of myros. In turning this book over to readers, I must ask a favor, especially from my fellow economists. If the ideas that are elaborated are to have any chance of being understood, it is crucial that they be approached with an open mind. Many of the concepts are non-conventional, and it is important that readers not attempt to interpret or recast them in a conventional frame of reference. To do so will almost certainly lead to confusion and frustration.
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Preface to Second Edition
Since 2007, the world has been in the grip of the most severe financial crisis since the Great Depression of the 1930s. When things go wrong, first instincts seem always to blame those in charge: bankers, central bankers, regulators, and government. Rarely, are ideas, or the lack thereof, the object of blame. However, in my view, much of the damage emanating from the housing boom of 2004–2006 could have been lessened, if not avoided altogether, had two key propositions from this book been understood and acted upon by regulators, namely: 1. That, over long periods of time, asset values cannot increase faster than the rate of growth of income. 2. That money should be created only for the finance of current production and the initial finance of investment in new capacity to produce. In light of current events, a major shortcoming of the first edition was inadequate attention to the interaction between money as a store of value and the mass phenomena of confidence and uncertainty. However, the purpose of this edition is not to rework the main body of the book, but rather to present in two new postscript chapters a framework for understanding the root causes of financial crises and why the latter are inevitable occurrences in economies in which money is available to hold as a store of value. The events since 1970 make it clear that current-day mainstream macroeconomics does not provide an adequate framework for dealing with the financial crises that are increasingly part and parcel of free-market economies. Neither of what are now the two standard textbook macroeconomic frameworks, the New Keynesian and New Classical Models, even admit of the possibility for financial crises to emerge, let alone provide provision for their alleviation. The problem is that neither framework allows for money to play its truly unique real-world role, namely, that of a risk-free store of value in the face of uncertainty. Missing, as well, is any notion in either model of a theory of production in which investment is determined not only by present-value considerations, but also by the availability and terms of finance. The purpose, accordingly, of this edition is to add a framework, based in
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substantial part on the long overlooked Chaps. 12 and 17 of the General Theory (and the equally slighted work of the late Hyman Minsky), in which money and finance, on the contrary, are center stage in determining the level and pace of economic activity. Except for minor editing and the addition of a few footnotes, the original text of the book is kept intact as Chaps.1–14. The new material is presented in Chaps. 15 and 16 and in a new Appendix D.3 Since a number of excellent chronicles of the 2007–2009 crisis already exist, most of the focus in the new chapters is on general characteristics of financial crises and the development of principles for assessing their occurrence. A great deal of attention in the analysis is on the distinction between risk and uncertainty, the interaction of uncertainty, confidence and liquidity preference, and on the need to guard against emergence of “casinos with banks.” However, a section on lessons for reform appears at the end of Chap. 16.4 Finally, the focus in Appendix D is on revision of the social-security system that involves replacement of the present system with individually owned (but Social Security administered) accounts that are partially voluntary, heritable, and (most important of all) self-financing and fully funded. As in the first edition of this book, I am indebted to Barbara Sands and Richard Newcomb for their comments, continuing interest, and support of the basic ideas of the book. I also wish to thank Alan Ker, Teodosio Perez-Amaral, Payam Sharifi, Charles Warden, and Dennis Weisman for their comments and criticisms, and (especially) John Britton for his careful reading of the new postscript chapters and for his insights and counsel on the functioning of current-day financial markets. Finally, I am grateful to Gillian Greenough of Springer-Verlag for initiating the idea of this edition and then seeing it through to publication, as well as to Nancy Bannister for her expert preparation of the manuscript. Tucson, AZ
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Lester D. Taylor
The original Appendix D is now Appendix E. For readers who might be primarily interested in financial crises and panics, Chaps.15 and 16 are essentially self-contained, and can pretty much be read in isolation. However, the concept of fluid capital is central in both chapters, so that those not familiar with this concept are nevertheless advised to begin with the Prologue and Chaps.1–3. 4
Prologue
Tales of Myros: Emergence of a Primitive Economy from an Economic State of Nature This is really a book about capital. However, as the word capital is so overused in economics as to be nearly meaningless in any specific sense, I am going to begin by employing a neutral word – myros – in its place. Later, once the notion is better understood, the word myros will be replaced with more conventional terminology. One of the major purposes of this book is to show that the concept of myros provides a root concept of capital which allows for most existing concepts of capital to be unified and related in a consistent fashion to one another. In addition, it will be seen that such a root concept offers a framework for integrating monetary and capital theory, and for analyzing the functioning of an economy, whether that economy is in a steady state of subsistence or in a process of sustained growth. Specifically, it will be seen that a conservation principle associated with myros emerges which both implies and imposes a variety of constraints on the macro behavior of an economy, constraints which make for straightforward understanding and analysis of such concepts as the real stock of money, real-balance effects, and the general price level. New and illuminating insights are also provided into aggregate supply and demand, natural and money rates of interest, the relationship between real and monetary economies, and economic growth and development. In introducing the concept of myros, I will begin in this introductory essay with several tales associated with a subsistence (but otherwise idyllic) island society. The only non-leisure activity on the island is time spent each day in a mine gathering that day’s subsistence rations of bread. Each individual is responsible for his/her own bread, and the only instruments used in gathering are hands. The climate is sufficiently benign that everyone sleeps comfortably under the stars, and while bread is storable, no one has ever felt a need to gather more than what is required for the current day. Bread is the only good on the island, and no one has any possessions of any type. In short, the island society is in what can be called an “economic state of nature.”
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I want now to consider several “escapes” from this primitive state: 1. One young man on the island unfortunately suffers recurrent dreams of being pounced upon by saber-toothed tigers while he sleeps and decides that he would be more comfortable enclosed at night by four walls and a roof (i.e., he would like to have a house). Materials for building a house are readily available, but the young man estimates that 10 days of his time will be required for construction, during which he will not be able to gather his daily rations of bread. However, since bread is storable, he decides to begin spending some extra time each day (thereby reducing the amount of time he has for leisure) gathering bread that will not be consumed on that day. He does this until his store of bread reaches 10 days’ consumption, whereupon he stops going to the mine and begins working on his house. Ten days later, the house is finished, as is his store of bread. Accordingly, he must once again spend part of each day in the bread mine, but secure in his house at night, he is no longer bedeviled with dreams of pouncing saber-toothed tigers. 2. Let us now turn our attention to a young woman on the island who loves her leisure so much that she wishes she had more of it. One day it occurs to her that if she had a “shovel” she could gather her daily ration of bread in half the time that it takes with her hands. She knows that a shovel can be made from materials on the island, but figures that it will take her 5 days to do so, during which time she will not be able to gather bread. Obviously, the prospect of spending extra hours gathering the bread necessary for sustenance while she is making the shovel is extremely distasteful, but the prospect of the greatly increased leisure that she will be able to enjoy once the shovel is made more than offsets the distaste. She accordingly proceeds to build up the necessary stock of 5 days’ consumption of bread, which is then consumed while she makes her shovel. With her shovel, she begins gathering her daily bread in half the time that had previously been required, and of course revels in her now greatly increased leisure time. 3. Another young woman on the island, we can call her Georgia, while happy with the amount of leisure she has, feels that she would enjoy it more if she had a picture to look at. Hence, she decides to spend some of her leisure in creating one. Once it is finished, one of her friends (named Alfredo) falls in love with the picture, and tells Georgia that he would much like to have one, too. Alfredo, though, is not such a good friend that Georgia is willing to devote any of her leisure time to creating one for him for nothing, but she says that she would be willing to make one for him in exchange for 2 days of bread. While Alfredo does not have any extra bread on hand, he finds the prospect of having one of Georgia’s pictures so desirable that (by spending extra time in the mine) he begins accumulating a stock of 2-days’ consumption of bread. Once the stock is completed, he gives it to Georgia in exchange for her promise to create a picture for him, which she immediately proceeds to do. 4. Finally, let us consider Thomas, who at an early age decides that he would like to spend up to 100 days near the end of his life in “retirement” (i.e., free
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of having to spend part of each day gathering his daily bread). He accordingly proceeds to accumulate such a stock of bread. Thomas completes his accumulation by age 50. At age 65, he quits going to the mine and begins consuming from his stock. In these episodes, we have the building of a house, “investment” in a tool, the creation of art, and the accumulation of a “rainy day” fund for retirement. In each case, before the desired end can be achieved, there must be accumulation of a stock of bread which allows for life to be sustained during the days that non-bread gathering activities are engaged in.5 In this primitive society, myros is accordingly represented by unconsumed stocks of bread. Thus: 1. In the first tale, myros comes into existence on the first day that the young man haunted by dreams of saber-toothed tigers gathers more bread than he consumes. On the day that he begins building his house, the stock of myros consists of 10-days’ consumption of bread. At the end of the 10th day of construction when the house is finished, the stock of bread has been reduced to zero and there is accordingly no more myros in existence. 2. In the second tale, myros comes into existence when the leisure-loving young woman begins accumulating a stock of bread to sustain her while she makes a shovel. Myros consisting of 5-days’ consumption of bread is built up and then subsequently invested in construction of the shovel. At the end of the 5-day construction period, a shovel has come into being, but the myros which provided for its construction has disappeared. 3. In the third tale, Georgia creates her first picture during her leisure time, so no prior accumulation of myros is involved.6 However, myros does come into existence when Georgia requires 2-days’ bread from Alfredo in exchange for the picture that he wants her to create for him. The tale is silent as to what Georgia does with the payment. If she should immediately take 2 days off from gathering bread, then her 2 days of myros will be consumed. However, if she should decide to keep her payment for a “rainy day,” then myros of 2-days’ consumption of bread will continue in existence. 4. In the fourth tale, myros comes into existence as Thomas accumulates a stock of bread for “retirement.” At age 65, Thomas’s stock of myros consists of 100-days’ consumption of bread. If he lives 100 days after this, his myros will have been exhausted, and he must resume daily visits to the bread mine. If he dies before his 100-day stock of bread is consumed, then the myros which remains can be passed on to his heirs.
5 The only exception is the first picture created by Georgia. However, this is an exception only because Georgia chooses to create the picture during her regular leisure time. Had she done it during food-gathering time, she also would have had to build up a store of bread to sustain her while she created her picture. 6 Escape from an economic state of nature clearly requires the existence of labor time that is not devoted to subsistence.
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In these stories, it should be obvious that myros comes into existence only when more bread is gathered in a day than is consumed – i.e., only when there is saving. Hence, myros is created only when there is production in excess of consumption. In the stories, myros is used up: (1) in construction of a durable good (a house) which provides consumption services in episode 1, (2) in investment in produced means of production (a shovel) in episode 2, (3) in the acquisition of a work of art (a picture) in episode 3, and (4) in eventual consumption in excess of production (consumption during retirement) in episode 4. The only use of myros that is not illustrated in the stories is the funding of current production. However, this use of myros could easily be accommodated in episode 3 if Georgia were to begin devoting her food-gathering time each day to the creation of pictures which are subsequently acquired by others in exchange for bread. The pictures thus created can be viewed as representing part of current production. The portion of bread received by Georgia which she consumes daily can then be seen as representing myros, which funds (or “finances”) current production. A major failing of current-day economic theory is that it does not allow for a material role for money. The most sophisticated Walrasian general equilibrium models, for example, remain at base models of barter economies, in that there is nothing essential in the models, which depends upon the presence of money.7 I now want to show, again in the context of the primitive island economy, that the concept of myros provides a foundation for understanding how money can emerge in an economy and also for understanding what is meant by a monetary economy. Assume that a period of time has passed on the island and that a stock of 1,000days’ consumption of bread has been built up by the inhabitants. Unfortunately, though, some new residents have put in an appearance on the island, namely, a colony of rats! As the new residents’ appetites for mined bread become manifest, so too does the need for some form of secure storage. One young man (whose name is Fargo) seizes upon the idea of building a “safe,” which he then makes available (for a small monthly payment in bread) to his fellow islanders for storing their stocks of bread. Each individual who has bread in Fargo’s safe is given a receipt listing the amount of bread that is in storage. By this time as well, quite a number of islanders live in houses, many of whose walls are graced by pictures that have been painted by Georgia. In fact, for some time Georgia’s paintings have been in such strong demand that she now devotes all of her working time to the creation of pictures which she subsequently exchanges for bread. In fact, Georgia’s paintings are so popular that existing examples are traded (for bread, of course) in a secondary market, and Georgia responds to this by regularly raising her prices. Although payment for the pictures is always in bread, it soon becomes apparent to those involved that bread removed from Fargo’s safe for payment in exchange for pictures almost immediately returns to the safe, so that transfer of ownership of the bread could be effected by the simple device
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This failing has long been recognized by Clower (1967) and Hahn (1975) and others. See also the recent series of papers by Kiyotaki and Wright (1989, 1991, 1993).
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of exchanging storage receipts or through written instructions to Fargo. As a consequence, endorsed storage receipts and “checks” began circulating as “means of payment” (i.e., money) in lieu of actual exchange of bread. Because of the storage fees collected for use of his safe and the popularity of her paintings, Fargo and Georgia become the wealthiest individuals on the island, and each of them has amassed a stock of 100-days’ consumption of bread. At various times in the past, both of them have made loans from their stocks to certain of their fellow citizens so that they could build houses without having first to accumulate the necessary stock of bread. The loans had always been repaid on schedule (with interest). However, once storage receipts and “checks” started to circulate, Fargo noticed that most of the bread in his safe, in fact, never left the premises. Accordingly, it occurred to him that he could begin making “house loans” from the bread of others in his safe rather than from just his own stock. In doing this, Fargo was aware that he was creating more claims to bread than there was actual bread on deposit. But he was always prudent to limit the creation of excess claims to a small fraction of the total, and there was never an instance of a requested delivery of bread from storage that was not promptly honored. In this tale: A continuing pool of myros (bread) has come into existence. Bread (or its surrogate in the form of storage receipts) has become the universally accepted means of payment – money as a medium of exchange has emerged. Four assets have come into being – bread, paintings, houses, and a safe (although no transactions involving the trading of houses or the safe for bread are mentioned as actually having occurred). An institution which provides “safe-deposit boxes,” “checking accounts,” “mortgage loans” (together with “interest”), and “bank notes” has come into existence. An institution for the creation of money has also come into existence. Let us now take the tale a bit further. Let us suppose over a period of time that Fargo, through his loan activities, has created bread claims totaling 2,000 days of consumption, but that only 1,000 days of bread in fact exist. In normal circumstances, this would not create any problems, for Fargo is always able to redeem in full any claims that are presented for actual delivery of bread. However, suppose that there is someone who is jealous of Fargo’s high standing in the island community and begins to spread a nasty rumor (completely unfounded, of course) that Fargo has begun living “high on the hog” and is consuming not only his own bread, but the bread of his fellow citizens as well. Panic ensues, and individuals rush with their storage receipts to get their bread from Fargo’s safe. There is a “bank run,” and Fargo is of course forced to close his doors. Any existing storage receipts obviously become worthless. In short, the primitive monetary system which had been established collapses.8
8 This contingency illustrates that, at base, money can be equated with “confidence.” Money can come into existence ex vacuo through trust and can be annihilated by “anti-confidence.” A money can accordingly fluctuate between being and nothingness.
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Prologue
Consider, now, a somewhat different scenario. Suppose that the rumor is the same, but that, rather than storage claims of 2,000 days of bread, there are in fact only 1,000. In this situation, Fargo would be able to honor claims as they were presented, and the bank run would almost certainly come to an end well before all 1,000 days of bread in the safe were paid out. Life would probably return to normal, and the monetary system would remain intact. For a final scenario, suppose that one night the colony of rats are able to breach the walls of Fargo’s safe and that, by the time this is discovered and the rats dispatched, half of the bread that was in storage is destroyed. Assume, as above, that the number of storage claims in existence is 1,000. If news of what happened were to spread, a bank run would almost certainly occur. As there are 1,000 claims in existence, but now only 500 days of bread, claims would again become worthless and the primitive monetary system would collapse as in the first scenario. The point being made in these stories is a simple one, and it involves the fundamental role of the pool of myros. In all three scenarios, there is a rush to “liquidity” because of a loss of confidence in the island’s “banker.” When it becomes apparent that the number of storage claims in existence exceeds the amount of goods, the claims lose their value and the monetary system collapses. However, the determining factor as to whether the system will in fact collapse is whether the number of storage receipts exceeds the amount of goods (i.e., the number of days of bread consumption) in the pool of myros. The conclusion, therefore, is that the real stock of money in this simple bread economy is determined by the number of days of bread consumption that is represented in the pool of myros. In the first two scenarios, this number is 1,000, but in the third scenario it was reduced to 500 because of the destruction caused by the rats.9 Generalization of this conclusion is straightforward, and will be one of the first tasks to be undertaken in this book. In a real-world economy, the goods produced are many and complex, and the goods side of myros can only be stated as a value (i.e., in monetary terms), specifically as the sum total of all final and intermediate goods in existence evaluated at current market prices. And just as in the simple bread economy, this aggregate value accordingly provides an upper bound on the real stock of money in an economy. Most of what I plan to do in this book simply involves variations on this and related simple themes. A final tale involves Auric, a cousin of Georgia. One day while on a walk in the hills, Auric crosses a stream and notices some attractive lumps of yellow metal shimmering below the surface of the water. Auric, who shares Georgia’s eye for beauty, picks up one of the lumps, likes it, and takes it home with him. A friend sees
9 In the third scenario, suppose that all of holders of storage claims understand what has happened and that holders of claims implicitly and simultaneously agree to share the loss proportionately so that no one presents any claims for redemption. It would be understood that the value of each claim has been halved, i.e., that each claim is now only for a half-day’s bread. In this case, while the nominal stock of money remains at 1,000, the real stock is only 500. The necessary devaluation of the stock of money would have occurred without a collapse of the monetary system. The likelihood of such a scenario occurring in real life is, of course, remote.
Prologue
xxi
it and likes it as well, and offers Auric a day’s bread for it. Since Auric knows where he can acquire more lumps, he accepts his friend’s offer. The word gets around that Auric has beautiful lumps of metal that he will exchange for bread, and he is besieged with islanders asking him to do so. Everyone, it seems, would like to possess at least one of the lumps. Auric is the only one who knows where the lumps come from, and of course he does not tell anyone, as he soon finds that he can obtain his daily bread much easier through exchange for these lumps of metal than by mining it himself. In time, the lumps of metal came to be universally acceptable in exchange, not only for bread, but for houses and paintings as well – in short, for anything for which payment in bread had previously been expected and required. Exchange rates, which had previously been denominated in terms of bread, now came to be denominated in terms of lumps of the metal. The metal is gold, of course, and what is described in this tale is the emergence of gold as still another form of money, together with an associated system of exchange rates. What allows gold to begin functioning as universal purchasing power is that, like bread, it is storable and universally desired. However, “desired” in this case is because of perceived beauty rather than its being necessary for life.
.
Contents
1
Premises and an Overview ...................................................
1
2
Myros and Other Concepts and Definitions .............................. 2.1 Myros. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Myros Recovery Charges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Human and Nonhuman Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7 8 11 12
3
The Macroeconomic Framework............................................. 3.1 An Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2 Constraints (or “Conservation Laws”) Imposed by the Pool of Fluid Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 The Determination of Asset Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Aggregate Demand and Supply. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.5 Macroeconomic Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
17 17 22 25 28 29
4
Interest and Money .............................................................. 4.1 Factors Making for the Existence of Interest . . . . . . . . . . . . . . . . . . . . . . . 4.2 Determination of Money and Natural Rates of Interest . . . . . . . . . . . . 4.3 A World with Fiat Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 The Concept of Velocity and the Demand for Money . . . . . . . . . . . . . 4.5 Power of the Monetary Authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 The Commercial Paper Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.7 Some Notes on Monetary Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
31 32 33 41 43 45 46 47
5
Production and Investment ................................................... 5.1 Capital and Production. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 From Production to Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3 Roles of the Money and Natural Rates of Interest . . . . . . . . . . . . . . . . . 5.4 Financing of Investment: An Illustration . . . . . . . . . . . . . . . . . . . . . . . . . . .
49 49 52 62 62
xxiii
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Contents
6
General Price Level and Inflation ......................................... 6.1 Defining the General Price Level. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Problems Arising from Excessive Monetization of Assets . . . . . . 6.3 The General Price Level and the Natural Rate of Interest . . . . . . . 6.4 Equilibrium in the Natural and Money Rates of Interest . . . . . . . .
65 65 72 75 76
7
Capital Values, Wealth, and Related Topics ............................ 7.1 The Aggregate Wealth of an Economy . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2 Money as Wealth and Real-Balance Effects. . . . . . . . . . . . . . . . . . . . . 7.3 Some Implications of Old Masters as a Store of Value . . . . . . . . . 7.4 Taxation of Capital Gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Forced Saving and Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.6 More on Excess Monetization of Assets . . . . . . . . . . . . . . . . . . . . . . . . . 7.7 Loan Defaults and the Stock of Money . . . . . . . . . . . . . . . . . . . . . . . . . . 7.8 Crowding-Out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.9 Burden of the National Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.10 Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.11 Commodity Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.12 Fluid Capital and the Gold Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.13 Demonetization and Monetization of Economies . . . . . . . . . . . . . . . . 7.14 Economic Growth with Deflation: The Period 1873–1896 in the USA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
79 79 80 81 83 85 87 88 89 92 93 94 95 98 101
8
Macroeconomic Equilibrium and Employment ........................
103
9
Capital Theory in Perspective .............................................. 9.1 Schumpeter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.2 Keynes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.3 Irving Fisher . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.4 Bo¨hm-Bawerk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.5 Jevons and Wicksell . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.6 Capital as Embedded (or Stored) Labor. . . . . . . . . . . . . . . . . . . . . . . . . . 9.7 Capital Theory as the Economics of Time . . . . . . . . . . . . . . . . . . . . . . . 9.8 Capital Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.9 Capital and Nonrenewable Natural Resources . . . . . . . . . . . . . . . . . . .
113 113 116 117 118 119 120 121 123 126
10
Opportunity and Sunk Costs ............................................... 10.1 Opportunity Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.2 The Measurement of Unit Incremental Cost. . . . . . . . . . . . . . . . . . . . . 10.3 Sunk Costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
129 129 131 132
11
Trade, Transfers, and Monetary Overhangs ............................ 11.1 Trade and Exchange Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.2 Monetary Overhangs and Capital Levies . . . . . . . . . . . . . . . . . . . . . . . .
135 135 137
Contents
11.3
xxv
Wealth Transfers and Monetary Overhangs: A Stylized Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Policies for Eliminating a Monetary Overhang: The Case of German Reunification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The German Reunification: An Assessment . . . . . . . . . . . . . . . . . . . . .
146 150
12
Questions Related to Consumption and Saving......................... 12.1 The Macroeconomics of Retirement Saving and Consumption . 12.2 Questions Related to Position Goods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.3 Questions Related to Engel Curves and Income Elasticities. . . . . 12.4 The Hierarchical Nature of the Pool of Fluid Capital. . . . . . . . . . . .
153 153 155 157 159
13
Questions Related to Economic Growth ................................. 13.1 The General Mechanics of Economic Growth . . . . . . . . . . . . . . . . . . . 13.2 Some Basic Truths Concerning Economic Development. . . . . . . . 13.3 Keynes and Economic Bliss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.4 The Endogenous Nature of Economic Growth. . . . . . . . . . . . . . . . . . . 13.5 The Role of Technological Change . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.6 Investment in Research and Development . . . . . . . . . . . . . . . . . . . . . . . 13.7 Economic Growth in Reverse: Large-Scale Disasters in Low-Income Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.8 Economic Growth and Different Stages of Development . . . . . . .
161 161 163 163 164 165 166
Themes and Counterthemes: Fluid Capital in Retrospect ...........
171
Postscript .............................................................................
247
11.4 11.5
14
15
Background and Tools for Understanding and Dealing with Recurrent Financial Crises ........................................... 15.1 The Impact of Uncertainty on Economic Activity . . . . . . . . . . . . . 15.2 Uncertainty and the Pace of Investment . . . . . . . . . . . . . . . . . . . . . . . . 15.3 Hedge, Speculative, and Ponzi Financing . . . . . . . . . . . . . . . . . . . . . . 15.4 The Many Burdens of Quasi-Rents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.5 The Banking Principle, Banking Disease, and Financial Panics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.6 Types of Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.7 Differences Between Goods Markets and Asset Markets . . . . . . 15.8 The Floor for Asset Values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.9 Asset Prices in a Financial Panic: the Role of a Lender-of-Last-Resort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.10 The Effect of Financial Panics on the Real Economy and the Role of Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15.11 Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
139
167 168
181 182 185 188 190 193 195 196 197 198 201 203
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16
Contents
Booms, Busts, and Financial Panics: The Financial Meltdown of 2007–2009.................................................................... 16.1 The Anatomy of Financial Panics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.1.1 Emergence from Recession. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.1.2 Awakening of Asset Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . 16.1.3 Some Signs of Danger . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.1.4 Casinos with Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.1.5 Getting Ready for a Fall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.1.6 Onset of a Panic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.2 The Fragility of Financial Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.3 A Digression on Uncertainty, Confidence, and Trust . . . . . . . . . . . . 16.4 Preludes to Panic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.4.1 The Layering of Financial Intermediaries. . . . . . . . . . . . . . 16.4.2 Lessening of Borrower and Lender’s Risk . . . . . . . . . . . . . 16.4.3 Spiking of Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.4.4 Asset Prices Outpacing the Increase in the Pool of Fluid Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.4.5 Explosion of Derivatives Trading . . . . . . . . . . . . . . . . . . . . . . 16.4.6 Activities of Hedge Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.4.7 Globalization of Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.5 The Uniqueness of Banks and the Lender-of-Last-Resort . . . . . . . 16.6 Some Observations on the Financial Meltdown of 2007–2009. . 16.7 Lessons for Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.8 Summary and Wrap-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
205 205 205 206 207 208 208 210 210 213 215 216 217 218 218 219 220 220 221 222 226 228
Appendix A...........................................................................
233
Appendix B ...........................................................................
241
Appendix C...........................................................................
247
Appendix D...........................................................................
255
Appendix E ...........................................................................
257
Bibliography .........................................................................
265
Index ...................................................................................
271
List of Figures
Fig. 3.1 Fig. 3.2 Fig. 3.3
Macroeconomic structure of an economy . . . . . . . . . . . . . . . . . . . . . . . . Suppy and demand in the capital market . . . . . . . . . . . . . . . . . . . . . . . . . Determination of the price of an asset . . . . . . . . . . . . . . . . . . . . . . . . . . . .
18 21 25
Fig. 4.1
Market for fluid capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
34
Fig. Fig. Fig. Fig.
Short-run marginal cost curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The investment decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From production to investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changing an on-going construction program in response to an expected increase in demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Changing an on-going construction program in response to an expected increase in demand, continuation . . . . . . . . . . . . . . . . Changing an on-going construction programs in response to an expected permanent decrease in demand . . . . . . . . . . . . . . . . . . .
51 53 56
61
Fig. 6.1 Fig. 6.2 Fig. 6.3
Irving Fisher's Equation of Exchange: version 1 . . . . . . . . . . . . . . . . Irving Fisher's Equation of Exchange: version 2 . . . . . . . . . . . . . . . . . Short-run demand and cost conditions for a typical firm . . . . . . . .
67 67 71
Fig. 6.4
Determining changes in the general price level . . . . . . . . . . . . . . . . . .
73
Fig. 8.1 Fig. 8.2 Fig. 8.3
Typical firm's short-run output decision . . . . . . . . . . . . . . . . . . . . . . . . . . Aggregate labor market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effect on output decisions due to a fall in real wages and decreased demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
108 109
Fig. 10.1 Investment in existing plant vs. a new plant . . . . . . . . . . . . . . . . . . . . .
134
Fig. 15.1 The investment decision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fig. 15.2 The investment decision with finance constraints . . . . . . . . . . . . . . . . Fig. 15.3 Price-output conditions consistent with hedge finance . . . . . . . . . . .
184 185 189
5.1 5.2 5.3 5.4
Fig. 5.5 Fig. 5.6
59 60
110
xxvii
Chapter 1
Premises and an Overview
As this book is rather sweeping in purview, it is appropriate to begin with a brief discussion of the premises which motivate and guide the analyses, together with an overview of the discussion to follow. The overarching concept in the book is that of myros (or what I will eventually rename as fluid capital). Myros is viewed as a fund (or equivalently a surplus), which comes into existence through saving out of current production and is extinguished through consumption, current production, and investment. Myros funds investment, current production, and consumption in excess of current income. Additionally, myros enables assets to acquire value, provides for both the existence and value of money, and is coextensive with the economic wealth of an economy. Myros is fundamental to the understanding of the macroeconomics of an economy, and what few macroeconomic laws that can be identified exist as consequences of the conservation laws, which myros imposes. Indeed, most of the analysis of the book can be viewed as a working through of the implications of these conservation laws. Most of the subject matter of economics, in my view, can be cast in terms of events that have their setting in mythical primitive economies of the type described in the Prologue. Consumption decisions are made, savings come into being, investments occur, values are created, exchange takes place, interest emerges, and money comes into existence in a variety of forms. In principle, these events are no different in their implications than their counterparts in a modern economy, so the device of reasoning from mythical primitive economies will be resorted to frequently.1 My approach to economics is neither classical, neoclassical, nor Keynesian. Equilibria play important roles in my framework, but more as “attractors” toward which activities and processes are drawn, as opposed to positions of actual attainment. Time is of fundamental importance in the framework, but the concern, 1
An implication of this paragraph is that there is no difference in principle between the laws governing development in a low-income economy and development in a high-income economy. Institutional settings can differ, but the conservation laws imposed by the pool of myros are invariant. Growth and development will be the focus of Chaps. 12 and 13.
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_1, # Springer ScienceþBusiness Media, LLC 2010
1
2
1 Premises and an Overview
for the most part, is with real time, rather than mechanical (or logical) time. My macroeconomic framework is more Keynes and classical, as opposed to Keynesian, and includes virtually no neoclassical elements at all. Yet my theory of value is thoroughly subjective, and therefore neoclassical. My vision of how an economy evolves and develops is pretty much in line with the events described in the Prologue. There are three things that have to occur in sequence in order for an economy to grow: 1. A pool of myros has to come into existence through saving. 2. The savings in this pool has to fund investment in produced means of production, thereby increasing the economy’s capacity to produce. 3. The increased capacity to produce must actually be utilized. Income is generated through the process of production and is viewed in this book as representing generalized “claim tickets” to the social product which is created.2 In a monetary economy, income is paid and received in the form of money. Money, itself, is viewed in this book as a social invention which allows specific claims on the pool of myros to be transformed into general claims. There are many ways that money can come into existence, but the standard way, in a monetary economy, is through a banking system, which creates universally transferable deposits for the purpose of financing current production and the initial finance of investment in newly produced means of production. The bulk of the money stock, accordingly, is in a continual state of creation and destruction. The pool of myros is increased by saving, both business and personal, and is depleted by funding for investment and current production (or what is usually referred to as working capital), and the excess of consumption over current income. There are two sides to the pool of myros, a “goods” side and a “claims” side. The “goods” side of the pool represents the goods that have been produced but not yet consumed, used as input into current production, or invested in newly produced means of production. The “claims” side of the pool of myros, on the other hand, represents the stock of generalized claims on goods that has come into existence as a result of current and past saving. A major deficiency of modern monetary theory is that much of the time it is silent as to how money actually comes into existence. For the most part, the stock of money is treated as exogenous, and the standard litany as to its genesis is of the form: “Assume that the quantity of money is doubled.” Probably the best known – and certainly the most mechanical! – metaphor for accomplishing this is Milton Friedman’s helicopter which flies about the countryside scattering money. The view in this book is that the stock of money is endogenous in most circumstances and that it comes into existence through the joint efforts of two parties: banks that create universally transferable deposits and businesses that demand these deposits in order to fund current production or provide for initial funding of new investment.
2
The term is from Schumpeter (1934).
1 Premises and an Overview
3
While it might seem otherwise, the foregoing does not ignore the fact that a significant part of the money stock in a modern economy is undated in the form of demand deposits and fiat money. The question which has to be asked, however, is how did these undated stocks of money come into existence in the first place. The answer, as we shall find, is that the processes of creation were for the most part once again endogenous. Moreover, one must also not conclude from this that, with the money stock being endogenous, monetary policy is sterile and ineffective. While the monetary authority cannot control directly the amount of money in existence, it can have strong indirect influence though effecting the terms upon which money is created and extinguished. As a consequence, there is a definite role for active monetary policy, but in ways that depart from conventional practice. We shall find that the conservation laws imposed by the pool of myros provide an upper bound to the real value of the stock of money, as well as an upper bound to the real value of the aggregate stock of real and financial assets.3 Moreover, we shall also find that the concept of myros provides a convenient vehicle for defining aggregate demand and aggregate supply and, by extension, the related phenomena of inflation and deflation, together with a reinterpretation of the venerable quantity equation of exchange. The standard macroeconomic question since the time of Keynes’s General Theory is whether a competitive market economy can come to rest in a position that is at less than full employment. Keynes’s answer was clearly in the affirmative, while the now canonical neoclassical answer is equally clearly in the negative. Although my own view is that such equilibrium-type questions are of limited relevance and interest, the conclusion in this book is nevertheless that an economy can be in equilibrium at less than full employment, and largely for the reasons advanced by Keynes. In my opinion, the canonical neoclassical model as formulated by Samuelson, Patinkin, and others suffers from two fatal defects as a framework for analyzing practical macroeconomic questions. These two defects are (1) a seriously flawed concept of capital and (2) a paradigm which continues to mimic nineteenth-century energy mechanics. Since the problems inherent in (2) are discussed at length in Appendix A, suffice it here to say that the basic problem involves violation of a stringent set of time invariances.4 The problems with the concept of capital that is used in neoclassical theorizing are both numerous and multifaceted, and in general are what this book is about. Not the least of the problems is that capital is not a single concept in the canon of economics, but a surfeit of concepts. The concept of myros developed in this book provides, in my opinion, an appropriate unifying definition of capital to which all other concepts of capital can be related in a consistent fashion. Unlike with the conventional neoclassical view of capital, myros is not interpreted as a substance,
3 4
Much will be made of these constraints in the postscript Chaps. 15 and 16. See Mirowski (1989, Chaps. 5 and 6).
4
1 Premises and an Overview
but rather as a fund which in general can only be measured as a value (i.e., in money terms).5 Among other things, this means that it is not meaningful, in my opinion, to view capital as a separate factor of production whose price is the rate of interest. In the framework of this book, there are two distinct concepts of the rate of interest, one associated with myros and the other associated with money. The myros rate of interest represents the price which equilibrates supply and demand in the market for myros, while the money rate of interest represents the price which equilibrates supply and demand in the money market. While these two interest rates are clearly akin to the natural and market rates of interest of Wicksell and the liquidity preference theory of interest of Keynes, there are, as we shall see, some important conceptual differences. I imagine that I am like most economists in seeing that the purpose of economic theorizing is to construct a framework for embodying economic relationships that are invariant with respect to time and place. Unfortunately, there are few economic relationships which, in my opinion, can aspire to the status of “law.” Engel’s Law regarding expenditure on food and the Law of Pareto regarding the upper tail of the distribution of income would seem to qualify, as would also a Law of Demand in some form or another. However, as the parameters in these “laws” vary with both time and place, it is clear that there are no relationships in economics which are on par with the great universal constants in the physical sciences. In my view, the closest thing in economics to universal laws is represented in the constraints that are imposed by the pool of myros. These “conservation laws,” as will be seen, impose constraints at each point in real time on the aggregate behavior of an economy’s agents. And this is true, moreover, no matter how the economy is organized politically or institutionally. For the most part, my micro-behavior views are fairly conventional, although not entirely. As far as consumer (or household) behavior is concerned, the framework of this book does not depend in any material way on specific structures of preferences, whether individuals optimize or satisfies, or just what. It is assumed that individuals work, receive income, consume, save, react to risk and uncertainty, and are subject to inertia and other real-time dynamical effects, but in general it is not critical just how these activities and processes are postulated to come about.6 On the production side, the analyses in this book are based upon the following inescapable facts regarding the real world: 5
That capital is a substance is uncritically accepted by the present generation of neoclassically trained economists was brought home to me a number of years ago by a bright young New Zealand economist, interested in macroeconomics and monetary theory, who was visiting Tucson for a few days. At one point, I asked him how he defined capital. His response was “Oh, capital! That is the K that appears in the aggregate production function!” Nothing, in my view, better illustrates the poverty of current-day capital theory. 6 Probably my most unconventional views concerning demand theory are that consumption behavior should be approached in terms of the structure and functioning of the brain and that consumption decisions are derivative from decisions to maintain acceptable levels of psychological and physiological well-being. For elaboration, see Taylor (1987, 1988, 1992) and Taylor and Houthakker (2010).
1 Premises and an Overview
5
1. Current production is produced from current productive capacity. 2. Current productive capacity is a legacy from yesterday and is a consequence of past investment decisions. 3. Investment today can only affect productive capacity in the future. Since the future is unknown, investment decisions are necessarily driven by expectations, which will almost always turn out to be wrong. As a consequence, a firm’s present capacity to produce will almost certainly not be optimal for serving today’s demand. What the firm can do, however, is to make optimal use of its current capacity and to optimize, on the basis of expectations of future demands, alterations in this capacity to take effect in the future. Moreover, the future in this context is not an infinite horizon, as is customarily assumed in the literature on investment theory, but a finite horizon that is determined by the firm’s normal construction period – i. e., the amount of time that the firm considers optimal for making new capacity operational in an orderly fashion. In making today’s investment decisions, the firm accordingly needs only to consider demands to the end of its normal construction period. Capacity decisions for serving demands beyond this period can be put off until tomorrow.7
7
Throughout this book, “today,” “yesterday,” and “tomorrow” will be used frequently. “Today” refers to the current period, or simply the present; “yesterday” refers to the past, usually the indefinite past, but occasionally (depending upon context) to the most recent past period; “tomorrow” refers to the future, usually the indefinite future, unless the context specifies otherwise.
Chapter 2
Myros and Other Concepts and Definitions
The purpose of this chapter is to establish the concepts and definitions that will be used in the sequel. One of the problems with economics is that much of its vocabulary consists of everyday words such as income, capital, and money that have fairly time-honored technical meanings, but meanings that frequently vary from economist to economist and from one generation of economists to another. As was noted in Chap. 1, capital is a notable example, as there are about as many concepts of capital as there are economists who have thought and written about it. Cost offers another example. Indeed, consider the following statements regarding cost, all of which can be readily found in the literature:1 (A) (B) (C) (D) (E)
Costs are subjective. Costs are objective. Costs determine choice. Choice determines costs. Prices must be set so as to recover costs.
Of these statements, B and E would seem to contradict A, while D would seem to gainsay C. But, before concluding that this is the case, consider the following: A telephone company is debating whether to spend $100 million in acquiring a commercial finance company, or to spend the same amount to replace an aging wire center in a revitalized and growing downtown area. The latter project is finally decided upon when the vice president pushing it threatens to resign if the project is not approved. Upon completion, the new wire center is allowed by the state Public Utility Commission to be put into the rate base at its full value and the telephone company is authorized to set rates that will recover the investment of $100 million over a period of 20 years. In choosing which project to pursue, the telephone company is guided by the opportunity costs of the two alternatives. In the event, it is decided that the risk 1
The following discussion is taken from Taylor (1991, pp. 465–466).
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_2, # Springer ScienceþBusiness Media, LLC 2010
7
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2 Myros and Other Concepts and Definitions
of losing the vice president in question is too high a price to pay not to replace the aging wire center. This opportunity cost, which is subjective, determines the choice of project, and accordingly illustrates statements A and C.2 The decision to replace the wire center sets in motion a stream of construction expenditures of $100 million. These expenditures are objective and are caused by the decision to replace the wire center. They accordingly illustrate statements B and D. Finally, in view of the social contract between the telephone company and the Public Utility Commission, a portion of the $100 million investment is to be depreciated each year according to agreed-upon accounting rules and this depreciation then becomes costs to be recovered through an appropriate set of rates. These costs illustrate statement E. The point of this story is not that cost is a confusing and confused concept, but that one word – cost – is being asked to do too much. There are, as the tale exemplifies, a number of different concepts of cost, and to refer to all of them indiscriminately as “cost” without proper qualification is to lead to confusion. The same is true for the word “capital.” The various concepts of capital – physical capital, financial capital, working capital, etc. – are all useful in context, but a single word, capital, cannot cover all contingencies of its use without proper qualification. What is needed is a root concept of capital which is both unifying and encompassing. And as was noted in the Prologue and Chap. 1, I believe that the concept of myros provides such an instrument.
2.1
Myros
The concept of myros will be approached in several different ways. To begin with, it is most useful to see myros as representing a pool of accumulated savings. This pool comes into existence through saving and is reduced through investment in produced means of production, the funding of current production, and consumption in excess of current income. The pool of myros has two sides – a goods side, which consists of stocks of unconsumed consumables and finished intermediate goods, and a claims side, which consists of the sum total of unexercised claims to both current and past production. In a barter economy (with property rights), the two sides of the pool of myros would be trivially the same, for the goods that are not consumed (i.e., that are saved) are actually owned by the individuals involved. The goods themselves are also the “claim tickets.” In a monetary economy, in contrast, the claim tickets in question initially take the form of money. This is because incomes in a monetary economy are received in money, and saving accordingly occurs through money not being spent. The monies saved can be subsequently exchanged for other forms of assets,
2
Buchanan (1969) provides a detailed discussion of the nature of costs and choice. See also Buchanan and Thirlby (1981).
2.1 Myros
9
both real and financial, so that the values induced on these assets become included in the claims pool on the claims side of the pool of myros. Of the events described in the Prologue, saving – and therefore myros – first emerges when the young man who suffers from bad dreams begins spending some extra time in the mine each day in order to build up a store of bread to sustain him during the 10 days that are needed to build his house. Just before he starts the house, the pool of myros for the economy accordingly consists of 10 days of bread. During the 10 days that the house is being built, the pool of myros is being depleted, and at the end of the tenth day, when the house is completed, the pool is empty. The economy at this point has no myros, as the myros that had existed was consumed during construction of the house.3 Myros again emerges when the young woman who loves her leisure starts working extra time in the mine in order to provide sustenance during the 5 days that she is making her shovel. At the end of the day before she begins work on the shovel, the pool of myros for the economy consists of 5 days of bread. However, the pool is once again depleted during the 5 days that she devotes to making the shovel. When it is completed, a shovel exists (as does also the young man’s house), but the economy once again has no myros. There can be no further investment in houses, shovels, or whatever until such time as additional myros comes into existence through saving. A pool of myros comes into existence a third time in the economy when Alfredo creates a stock of 2 days’ bread in order to acquire Georgia’s picture, and then again when Thomas decides to create a retirement fund. From this point on in the story, the pool of myros is never empty, though it ebbs and flows as reserves of bread are increased and then reduced as a result of retirement saving, housing construction, investment in a safe, etc. Other standard concepts of capital are also evident in the story, namely: 1. Physical (or real) capital, as exemplified by the house, shovel, and safe. 2. Working capital, as exemplified in the bread that is consumed by Georgia while she is producing paintings. 3. Financial capital, as exemplified by the “warehouse” receipts held by the individuals with bread on deposit in Fargo’s safe. 4. Money, as exemplified by circulating “warehouse” receipts for bread on deposit in Fargo’s safe, notes instructing Fargo to transfer bread from one “account” to another, and finally lumps of gold.4 An alternative way of arriving at the concept of myros is to begin with a gross concept of “capital” – without an adjective! – defined as the difference, measured from time immemorial, between the sum total of production and the sum total of 3 As noted in the Prologue, implicit in the foregoing is the assumption that latent labor is available in the form of working hours that can exceed the time needed to mine one’s daily bread. A subsistence economy that does not have this option is not able to endogenously create myros. 4 Obviously, there are other ways that money can come into existence in a primitive economy. For a formal discussion of the conditions that a commodity has to satisfy in order for it to begin functioning as money, see Clower (1967). See also Kiyotaki and Wright (1989).
10
2 Myros and Other Concepts and Definitions
consumption. Consumption in this context is to be broadly construed as consumption in the usual sense of the word plus capital used up in production (including wastage and deterioration) and physical capital of the “white-elephant” type that never produces any output. “Capital” in this sense is thus a stock (or, equivalently, a surplus). At any one point in time, this stock will consist of two components, a fixed (or sunk) component and a fluid (or liquid) component. The fixed component is represented by the undepreciated portion of produced means of production (of which plant and equipment, as usually interpreted, account for the major share), while the fluid component refers to a pool (or stock) of finished goods and goods in process of production. The fluid component of capital can also equivalently be viewed as being measured by the depreciation reserves of currently existing produced means of production plus the excess of past and current savings over past and current investment.5 The fixed (or sunk) component of capital represents what most writers have in mind when they either explicitly or implicitly refer to physical capital. The only important difference is that my definition of fixed capital refers only to the undepreciated portion of the physical stocks of produced means of production. This difference is important to the measurement of fluid capital, but not to the ability of the physical capital to produce output and generate income. A piece of physical equipment can be highly productive even though it is fully depreciated and carried on books at a value of zero. The fluid component of capital thus represents the fund that is available to be drawn upon to finance and sustain investment in newly produced means of production, to fund the production of consumption goods, and to fund consumption in excess of current income. This fund provides for both finance and subsistence – finance, because the stock of goods contained in it can be monetized, and subsistence, because the goods themselves are available to be consumed during periods of production. The fluid component of capital clearly corresponds to what most writers would seem to have in mind when they refer to circulating, working, or liquid capital. Ricardo’s subsistence fund is clearly related to this concept of capital, as is also the “wages fund” of other Classical writers. The fluid component of capital is as what I call myros. This being the case, myros and fluid capital will henceforth be used interchangeably. The characteristic of the fluid capital that makes it “fluid” or “liquid” is that, it is free to be embodied, through investment, in anything, anywhere. This characteristic is usually referred to as fungibility.6 Fluid capital is perfectly fungible, unlike sunk capital which is at best only partially fungible.7 5
Depreciation, as it is used in this paragraph, as well as throughout this book, will be clarified in the next section. 6 In the neoclassical growth and investment literature of the 1960s and 1970s, the term used was putty, as in “putty-clay” models. The clay, of course, referred to fixed (or physical) capital. 7 An existing airplane is perfectly fungible between different routes, but the capital that is embodied in the plane can be transformed into an office building (say) only through a recovery of that capital back into the pool of fluid capital through depreciation charges against the revenues generated by the plane.
2.2 Myros Recovery Charges
2.2
11
Myros Recovery Charges
A concept which finds heavy use in the discussion to follow is depreciation (or what I will call myros recovery charges). Since my concept of depreciation differs from what is traditionally employed in the literature, it is critical that depreciation as used in this book be understood at the outset. In conventional neoclassical theory in which capital is treated as one of the factor inputs in a production function, depreciation is represented as the “using-up” (or “consumption”) of capital which occurs during the course of production. That physical capital represented in produced means of production is subject to wear and tear from usage or deterioration with the passage of time, there is no doubt, and to recognize this in determining an economy’s capacity to produce is of obvious relevance. However, this is not the concept of depreciation that will be used in this book. Instead, depreciation in this book is defined in terms of a charge against quasirents which returns capital embodied in produced means of production back into the pool of myros.8 Viewed in this way, depreciation is simply an accounting device for transforming (over some relevant horizon) sunk capital back into fluid capital. Depreciation, as the term will be used in this book, thus represents an instrument for effecting saving, and bears no necessary relationship to physical wear and tear or deterioration.9 Henceforth, whenever depreciation in the conventional neoclassical sense is at issue, it will be referred as economic depreciation, wear and tear, or some such physical equivalent. Depreciation, as used here, will be referred to as myros recovery charges. To fix the essential ideas, consider the following example. Assume that a firm has just purchased a newly produced machine with an expected useful operating life of 10 years at a cost of $10,000. Assume, however, that in deciding to make the investment the firm used an investment (or “payback”) horizon of 5 years, rather than the expected 10-year life of the machine. Assume that in the first year of operation that quasi-rents of $4,000 are generated by the machine and that the firm’s financial managers decide to make a myros recovery charge of $3,000 against these quasi-rents.Assume that the $1,000 that remains is kept as retained earnings. At the end of the first year, therefore, the firm’s books will show a profit of $1,000, cash balances of $4,000, a myros recovery reserve of $3,000, retained earnings of $1,000, and an undepreciated balance for the machine of $7,000. Assume that during the next 4 years quasi-rents continue to be $4,000 each year, that myros recovery charges of $3,000, $2,000, $1,000, and $1,000 are made, and that all profit is paid out as dividends. At the end of the 5 years, the firm will show cash balances of $11,000, myros recovery reserves of $10,000, retained earnings of $1,000, and a value of zero for the machine. However, since the machine is still
8
As used in this book, quasi-rents represent the difference between revenues and the out-of-pocket costs (but only the out-of-pocket costs) of producing those revenues. 9 The accounting aspects of depreciation will be discussed in detail in Chap. 9.
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2 Myros and Other Concepts and Definitions
“healthy,” it will be expected to continue generating quasi-rents for another 5 years even though it is now fully depreciated. While this example may seem an almost trivial exercise in elementary accounting, its essential point is to demonstrate that the myros recovery charges that recover the $10,000 that was initially invested in the machine need bear no necessary relationship to the actual physical life of the machine. Absent tax considerations, the firm is free to take the myros recovery charges in any manner that it chooses (so long as the charge in any year does not exceed that year’s quasi-rent). After 5 years, the $10,000 of fluid capital that was originally embodied in the machine is again fluid capital. No myros remains sunk in the machine even though the machine continues to exist and to generate output and income.
2.3
Human and Nonhuman Capital
The concept of human capital, and its distinction from physical capital, is central to current economic analysis. As with physical capital, human capital comes into being through investment; hence its creation represents consumption of fluid capital. With physical capital, as we have seen, there are two types of depreciation to be considered: physical depreciation, which represents the physical destruction or deterioration from use or the passage of time, and fiducial depreciation (i.e., myros recovery), which represents the repatriation of the fluid capital expended in the physical capital’s original creation. With human capital, physical depreciation can itself take two forms. The first relates to the deterioration which occurs with lack of use and aging, while the second is the complete destruction which occurs at death. Unlike for physical capital, fiduciary depreciation for human capital seems remote, but the fact that human capital completely destructs at death means that the capacity to produce is permanently reduced unless replacement has occurred through education and training of a younger generation. The expenditures associated with this can be viewed as fiduciary charges against the earnings of the current stock of human capital. Whether this takes the form of prior saving or spending out of current income, the effect is the same: the fluid capital sunk in the sunset generation of human capital is repatriated and reinvested. While the general principles governing the creation and renewal of human and nonhuman capital are the same, human capital differs from physical capital in its degree of fungibility. Human capital is clearly the more fungible, in that it can entertain different uses much more readily than can physical capital. Even within human capital, fungibility differs in that knowledge (or intelligence)-based capital has much greater fungibility than skill-based capital. With fungibility, the myros embodied in produced means of production can traverse different uses without the need to be repatriated back into fluid capital and then reinvested. Fungibility, therefore, clearly increases the efficiency of a given stock of produced means of
A Glossary of Concepts and Definitions
13
production, and is the reason why intelligence-based human capital, in general, has an advantage over skill-based human capital. I now turn to a glossary of concepts and definitions of terms which will be used throughout the book. The listing which follows is logical, rather than alphabetical.
A Glossary of Concepts and Definitions Goods
Production
Social dividend
Income Saving Produced means of production
Investment
Quasi-rents
Myros recovery charges
A good is anything for which individuals are willing to exchange their labor or fruits of their labor. Production is the creation of goods through the combining of labor with natural resources and produced means of production. The social dividend represents the net output (but gross of depreciation) from production for an economy. In most circumstances, the social dividend can be identified with Gross Domestic Product. Income is generated by production and represents “claim tickets” to the social dividend. Saving represents that part of the social dividend that is not currently consumed. Produced means of production are additions to the capacity to produce that are themselves produced. Produced means of production are temporary resources, in contrast to natural resources which are permanent. Produced means of production are durable, but nevertheless will eventually disappear if not maintained or replaced. Investment represents the creation of produced means of production. The goods that are needed in the creation of produced means of production are drawn from the pool of fluid capital. Quasi-rents represent the difference between revenues and the out-of-pocket costs (but only the out-of-pocket costs) of producing those revenues. Myros recovery charges represent charges against quasi-rents that return the capital embodied in produced means of production back into the pool of fluid capital. Alternately, myros recovery charges can be seen as the process whereby physical capital is transformed back into fluid capital.
14
Sunk capital
Money
Monetization
General price level
Natural rate of interest
Money rate of interest
Assets
2 Myros and Other Concepts and Definitions
Sunk capital represents that part of the fluid capital embodied in produced means of production that has not yet been transformed (or recovered) back into fluid capital through myros recovery charges against quasi-rents. Money is a social invention which allows the pool of fluid capital to be transformed into universal purchasing power. Monetization is the process by which the pool of fluid capital is transformed into universal purchasing power through the granting of loans denominated in money. There are many forms that monetization can take, including the creation of bills of exchange, bank notes, checking deposits, etc. Once a unit of account is established, the general price level is determined by the pool of purchasing power that is established by monetization of assets in conjunction with the stock of goods represented by the goods side of the pool of fluid capital. The general price level is established initially by selecting some good as the numeraire and expressing the prices of all other goods in terms of units of this good. Prices in terms of the numeraire’s price may in turn be expressed in terms of the money unit of account. The natural rate of interest is the price which equates the demand for fluid capital with its supply. The money rate of interest is the interest rate on money loans, and represents the price for monetizing the pool of fluid capital. In a world of uncertainty and a fractional reserve banking system, the lower bound to the money rate of interest is ultimately determined by the price that has to be paid to get holders of the primary money to give up their immediate claims to it (i.e., liquidity preference). Assets represent instruments for transferring purchasing power over time. They come into existence because those with claims on the pool of fluid capital are willing to give up some of their claims in exchange. Assets can take a number of different forms – money, goods, old masters,
A Glossary of Concepts and Definitions
Wealth
15
loans, property rights in produced means of production, etc. Wealth for an individual is represented by the sum of current income plus the value of all assets held. Wealth for an economy as a whole (viewed as a closed system) is given by the sum of current income plus the value (measured in current prices) of all stocks of unconsumed consumables.
Chapter 3
The Macroeconomic Framework
This chapter focuses on the macroeconomic framework, which guides the analyses of the book. We shall begin with an overview that describes how the major components of the framework relate to one another. The constraints (or “conservation laws”) that are imposed by the pool of fluid capital will then be discussed, followed by discussions of the determination of asset values and aggregate demand and aggregate supply. The chapter concludes with a description of the conditions, which define macroeconomic equilibrium.
3.1
An Overview
The essential features of the macroeconomic framework are given in Fig. 3.1. We start with the big box near the right hand side of the figure labeled Capacity to Produce. This box symbolizes the current capacity of the economy to produce goods and services and to generate income. At any point in time, the capacity of an economy to produce is determined by three factors symbolized by oblongs feeding into Capacity to Produce: population, permanent resources, and temporary resources embodied in produced means of production.1 Population obviously represents the labor resources that are available to be employed in production.2 Included in permanent resources are those resources, such as land and sunshine, that are not consumed in production and remain permanently intact. Produced means of production, on the other hand, represent resources that, although durable, periodically require replacement if they are not to 1
Cf. Hayek (1941, Chap. 5). The population resource base is assumed to be measured in terms of hours of “common” labor, as exemplified (say) in the mythical island economy in the Prologue of 8-h days spent mining bread. In a modern economy, this might be measured in terms of the skills of a typical high-school graduate. Labor skills beyond the basic skills are treated as human capital and included in produced means of production.
2
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_3, # Springer ScienceþBusiness Media, LLC 2010
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3 The Macroeconomic Framework
FLUID
CAPITAL
Claims
Myros Recovery Charges
Goods Retained Earnings Personal Saving
Income
Output Consumption
Investment
CAPACITY TO PRODUCE Money Market ‘Capital’ Market
FIDUCIAL STRUCTURE
Produced Means of Production
Population
Permanent Resources
Fig. 3.1 Macroeconomic structure of an economy
disappear.3 Produced means of production are assumed to include both physical plant and equipment (i.e., physical capital) and intangibles such as human capital and technology. At any point in time, the production capacity of an economy is fixed. The only open decisions regarding this capacity relate to the intensity with which it can be utilized. Actual operation of capacity yields output and generates income as symbolized by the oblongs labeled Output and Income. The oblong for Income is shown as standing by itself, while that for Output is included in the box labeled Fluid Capital. Output is shown as being wholly contained in Fluid Capital in order to emphasize that the goods and services from current production form the bulk of the goods side of fluid capital; inventories of previously produced goods form the rest. Two things can be done with income: it can be used to purchase consumption goods or it can be saved, as given by the sum of personal saving, retained earnings, and myros recovery charges. The box in the upper left of the figure symbolizes the pool of fluid capital. This pool is enlarged by saving and reduced by investment in produced means of
3
This threefold representation of cooperating determinants of production is the one employed by Hayek in The Pure Theory of Capital. While “original powers of the soil” may have seemed inexhaustible to the Classical economists, present-day land uses clearly suggest otherwise. Even sunshine in many areas can no longer be taken for granted. Accordingly, it is debatable whether permanent resources should even be listed as a separate category.
3.1 An Overview
19
production, funding of current production, and consumption in excess of income.4 The box for Fluid Capital is divided in two equal parts, one labeled Goods and the other Claims. This division symbolizes that fluid capital is seen as consisting of two sides, a goods side and a claims side. Saving consists of two components, personal saving and business saving. Personal saving is identified with that part of income, which is not consumed (i.e., with the oblong labeled Personal Saving), while business saving is identified with the oblongs labeled Retained Earnings and Myros Recovery Charges.5 Investment, which is symbolized by the oblong labeled Investment, converts fluid capital into fixed (or sunk capital) and thus adds to the capacity of the economy to produce and to the potential of the economy to generate income. As with the current production of consumption goods, investment must also be funded from the pool of fluid capital. A common misconception is that investment must be funded by current saving but this is not necessarily the case. For saving (whether personal or business), defined as the difference between current income and current consumption, is just the current flow into the pool. The pool of fluid capital is itself a stock and is the result of both current and past saving.6 So long as the pool is not empty, investment can be funded even if current saving is zero.7 The financial system is represented by the box labeled Fiducial Structure. The Fiducial Structure comprises the banking system and a variety of financial intermediaries. This is where money is created and assets and liabilities are generated in exchange for claims on the pool of fluid capital. Money is created by commercial banks in the form of short-term loans.8 Such loans are made for two purposes: (1) finance of current production and (2) initial finance of investment in newly produced means of production.9 Expectations are central – and indeed are the drivers! – in both cases, short-term expectations in the case of current production and long-term expectations in the case of investment. Owners of current productive capacity form expectations of the output that can be sold during the current period and take these to their bankers. The outcomes of these
4
It might seem that consumption in excess of income should be treated as negative savings and netted into saving. This is not done because the bulk of consumption in excess of income represents the funding of retirement consumption, and how retirement consumption is financed has important macroeconomic implications. These questions will be discussed in Chap. 12. 5 For present purposes, government saving and investment will be subsumed in business saving and investment. 6 Throughout this book, saving (singular) will refer to saving out of current income, whereas savings (plural) will refer to the accumulation of past saving. 7 In my view, recognition of the possibility of this was one of the most critical insights of Keynes in the General Theory. 8 Money that is created by the discounting at the central bank of IOUs purchased by banks in the commercial paper market will be discussed in Chap. 4. 9 Money creation for the finance of consumption will be ignored for the moment.
20
3 The Macroeconomic Framework
“banker conferences” then determine the utilization rate of the existing capacity to produce. If expectations are rosy, and bankers are in agreement, then the utilization rate will be high. The opposite will be the case if short-term expectations are pessimistic. The money and “capital” markets are symbolized by the two oblongs in the box for the fiducial structure. The money rate of interest – i.e., the price at which fluid capital is monetized – is determined in the money market. Supplies and demands for fluid capital meet in the “capital” market, as do also the supplies and demands for the various types of assets. The natural rate of interest is determined in this market, together with the structure of asset holdings and prices. The “circular flows” connecting the various boxes and oblongs can be summarized briefly as follows. Current production decisions are based upon expectations regarding the revenues that proposed output will generate. On the assumption that these plans are accepted by commercial banks, money from short-term loans is used to buy raw materials and intermediate goods and to pay wages and salaries. Incomes are generated. Wage and salary receivers use some of their income to purchase consumption goods and save the rest.10 The production period draws to a close, and the goods that have been produced are sold. Production loans are then repaid from the revenues generated from the sale of output, and the process begins anew. The difference between the revenues, which are received from the sale of output and the costs of production, represents the quasi-rents from current production.11 Interest and other fixed obligations have to be paid from these quasi-rents. Myros recovery charges are made against the quasi-rents as well. Whatever remains after all of these “costs” have been deducted represents the net profit for the production period.12 This net profit can be paid out to owners as dividends or it can be kept as retained earnings. Business saving for the period will consist of the sum of retained earnings and myros recovery charges. Total saving for the economy will consist of business saving plus net personal saving. The pool of fluid capital is increased or decreased depending upon whether the net addition of goods to the pool is positive or negative. Just as current production requires money to purchase inputs and to pay wages and salaries, the same is true for investment in new capacity to produce. In this case, the money required may be obtained directly from the capital market or
10
It will be noted that consumption is connected to both Goods and Claims in the box labeled Fluid Capital. This reflects the fact that consumption annihilates claims as well as goods. 11 It is important to emphasize that quasi-rents as defined in this book are gross of any capital charges. The costs, which are subtracted from revenues to arrive at quasi-rents, represent only the literal out-of-pocket expenditures that are incurred in production. In not including capital “user costs” as part of production cost, I am of course departing from both Keynes (in the General Theory) and conventional usage. As discussed in Chap. 2, capital charges in this book represent accounting charges against quasi-rents, which transforms the fluid capital originally embedded in produced means of production back into fluid capital. 12 Taxes obviously must also be paid out of the quasi-rents.
Interest Rate
3.1 An Overview
21 D
S
DDS + DCP + DI + DR DCP + DI + DR DI + DR DR
$
Fig. 3.2 Suppy and demand in the capital market
alternatively it may be obtained through short-term bank loans, which are subsequently refinanced in the capital market.13 Since wage and salary earners (and also dividend receivers) receive payment in money, saving initially occurs in the form of money. Savers, both individuals and businesses, have then to decide how to hold their unexercised “claim tickets” – whether as money or as some other asset or combination of assets. Sorting all of this out is a primary function of the capital market. Specifically, what goes on in the capital market is equilibration of supply and demand on the claims side of the pool of fluid capital. The price, which gets determined in this market, is the natural rate of interest. Supply in the capital market is represented by the sum total of all unexercised claim tickets to the social dividend. Demand (i.e., the willingnessto-hold the claims), on the other hand, consists of the demand for these claims on the part of existing holders (i.e., reservation demand), those wishing to invest in new produced means of production, owners of productive capacity wanting to fund current production, and those wishing to consume in excess of their current income. Supply and demand in the capital market is depicted graphically in Fig. 3.2. Since, at any point in time, the pool of fluid capital is fixed, the supply curve is simply the vertical spike labeled S. The willingness-to-hold curve, in contrast, has the usual downward slope of a demand function and is represented by the horizontal summation of the four demand categories just listed. DR represents the reservation demands of existing claim holders who are holding their claims in the form of money. To DR is then added investment demand DI , demand for funding current production DCP , and demand on the part of dissavers DDS to obtain the total willingness-to-pay function D. The natural rate of interest is then determined at the point where D intersects with S. 13
Cf. Keynes’s (1937b) “finance” motive for holding money.
22
3 The Macroeconomic Framework
Since all claims on the pool of fluid capital initially take the form of money and since the “active” demanders for these claims are themselves demanding money, the capital market also, in fact, encompasses the money market.14 Demanders can acquire the money that they want in either of two ways: (1) by taking out short-term loans from banks or (2) by borrowing existing money from its current owners. In the first case, new money is created, while in the second case money being held as an asset (whether by individuals or by financial intermediaries) is transformed into money to be used as a medium of exchange.15
3.2
Constraints (or “Conservation Laws”) Imposed by the Pool of Fluid Capital
As was noted in Chap. 1, neoclassical general equilibrium theory is plagued by an attempt to fuse two inconsistent theories of value, a classical substance theory for describing the creation of value in production and a vector field theory for describing a general equilibrium in exchange.16 The result is a combining of two inconsistent conservation principles, one which conserves value in the transformation of inputs into outputs but which alters endowments, and the second which takes endowments as given and conserves the sum of utility and expenditure through exchange. The purpose of the present section is to discuss the conservation principles, which inhere in the concept of the pool of fluid capital. These principles, although much less comprehensive than the conservation principles postulated by neoclassical theory, are nevertheless free of inconsistencies. We begin by making explicit two macroeconomic identities that are used throughout this book. The first of these is that income generated from current production is assumed to be equal to the value of output measured in current prices, while the second (which is actually a consequence of the first) is that saving (i.e., the difference between current income and current consumption) is equal to the value in current prices of that part of current output, which is not consumed. The equality of income and the value of current production is a conventional identity in national 14
“Active” demanders refer to those desiring to invest in newly produced means of production, current producers, and those consuming in excess of their income. Reservation demanders, in contrast, represent “passive” demanders. 15 In a purely bank-money economy, the holding of money as an asset would seem to create a problem in that it is obviously impossible for all of the loans, which created the money in the first place to be repaid. What has to happen in this situation is that a part of the original loans – specifically, the amount that is being held as an asset – must be “rolled over.” For banks to be willing to do this, there must be prospects of an increased stream of revenue (valued in current prices), foreseen by businesses and accepted as valid by banks. Otherwise, banks would not be willing to increase the total amount of loans. Thus, it follows that, in a purely “inside-money” economy, an asset demand for money can only be accommodated if the economy is expanding. This conclusion will be discussed in more detail in Chap. 7. 16 See Mirowski (1989, Chaps. 5 and 6).
3.2 Constraints (or “Conservation Laws”) Imposed by the Pool of Fluid Capital
23
income accounting and is therefore hardly novel. The equality of saving and the value in current prices of the unconsumed part of current production also corresponds to another well-known identity in macroeconomics but in a nonstandard form. The identity in question is Keynes’s identity (as opposed to his equilibrium equality) between saving and investment. As will be discussed later, however, investment as defined here is not the same as Keynes’s definition of investment. Money has been defined generically as a social invention, which allows specific claims on goods to be transformed into general claims through the creation of universal purchasing power. Two points about this definition need emphasis. The first is that money is viewed as a social invention, while the second is that money, qua money, is defined in terms of universal purchasing power, i.e., as a medium of exchange. As has been noted, one of the problems with conventional Walrasian general equilibrium theory is that money does not play a useful role. Money can be introduced into the theory but not in a way that mimics its contribution to economic activity in the real world.17 This is not the case here, for money emerges naturally as a social invention, which allows specific claims in the pool of fluid capital to be transformed into general claims. This occurs through the process of monetization. Effecting this monetization is the primary purpose of a well-functioning banking system. The conservation principles, which motivate this section can now be illustrated through the following propositions involving the pool of fluid capital: 1. The real stock of money is bounded by the pool of fluid capital evaluated in current prices. 2. The pool of fluid capital evaluated in current prices also provides an upper bound to the aggregate value of an economy’s assets. That the pool of fluid capital evaluated in current prices imposes an upper bound on the real stock of money follows almost immediately from the fact that the pool of fluid capital evaluated in current prices imposes an upper bound on the real stock of purchasing power. If a stock of purchasing power is created that is greater than the goods represented in the pool of fluid capital evaluated in current prices, then the general price level must necessarily increase, thereby reducing the real value of the stock of purchasing power that had initially been created. If this stock of purchasing power consists entirely of money created (by whatever means) without reference to the value of the pool of fluid capital in current prices, the real value of this stock of money will be reduced as prices of the goods contained in the pool of fluid capital are bid up. Moreover, it should be evident that this will be true independently of whether the money stock in question consists of bank, commodity, or fiat money or some combination of the three. That the pool of fluid capital evaluated in current prices also imposes an upper bound to the aggregate value of an economy’s assets (or what can be called the aggregate “wealth” of an economy) is a bit more subtle, for this conclusion follows from the claims side of the pool of fluid capital rather than from the
17
See Hahn (1975).
24
3 The Macroeconomic Framework
goods side. As has been stated, the claims side of the pool of fluid capital represents the accumulation of unused claim tickets to the social dividend. These unused claim tickets do not manifest any specific property rights to the goods embodied in the pool of fluid capital, but represent instead unutilized income from both the present and past. As we have seen, these unused claims are initially denominated in money (since income is received in money) but will currently be represented in holdings of a variety of financial and real assets (including money held as a store of value). The question, which must be addressed, is how do the values of these two classes of assets – that is, financial and real – combine to form the aggregate wealth of an economy. Are the two values additive or inclusive? Wealth for an individual can properly be viewed as the current flow of income plus the value of all real and financial assets (including such things as Old Masters and rare stamps and coins). Real and financial assets represent individual wealth because their value can be realized for money through sale. In a closed system, however, the value of real and financial assets cannot be converted to money in the aggregate because of an obvious fallacy of composition. Everyone would be trying to sell at the same time and there would be no buyers. Accordingly, wealth in the aggregate at any point in time is, in essence, measured simply by the pool of fluid capital evaluated in current prices.18 A simple example can show that the aggregate value of an economy’s assets is inclusive of the values of real assets and financial assets rather than additive. Consider a firm, which owns produced means of production and which, in turn, is owned by the holders of its equities. The produced means of production have value, and the equities have value, but the total value of the firm is not the sum of the value of the produced means of production owned by the firm and the value of equities in the firm, for the former will be included in the latter. The total value of an economy’s assets, accordingly, must be approached in terms of the total value of the assets that are held by the owners of the unused claim tickets to current and past social dividends. It is evident that the value of these claims in the aggregate cannot be greater than the value in current prices of the stock of fluid capital, which in turn means that the aggregate value of an economy’s assets cannot be greater than that amount.19
18
Whether money is a component of aggregate wealth will be dealt with in Chap. 7. That the total value of tangible wealth is constrained by the value (in current prices) of the stock of fluid capital has important implications for possible excess monetization of the stock of fluid capital. The usual type of commercial loan may be secured by claims to produced means of production, but the claims involved are really claims against current production. So long as the amount of purchasing power that is created does not exceed the current value of the stock of fluid capital, inflation cannot be a problem (except to the extent that expectations may be in error). However, if the value of tangible wealth is monetized as well as the current production that these assets produce, there is great danger that too much purchasing power will be created. The implications of this will be discussed in Chap. 7 and at length in Chaps. 15 and 16.
19
3.3 The Determination of Asset Values S
Price
Fig. 3.3 Determination of the price of an asset
25
D d
s
p
D
s
d Q
3.3
The Determination of Asset Values
Let me now turn to asset values and the way that these are determined. Four types of assets will be considered: equities, bonds, “Old Masters,” and money. To keep the discussion manageable, both equities and bonds will be discussed with reference to firms. Firms are viewed as being the direct owners of capacity to produce. Equities represent ownership claims to produced means of production, and their yields or returns consist of residual quasi-rents. Their prices are determined through an interaction of supply and demand. The prices of bonds, on the other hand, represent the current valuations of the stream of payments in the bond contracts.20 It is obvious that a good (or an asset) for which there is a fixed quantity in existence must necessarily be held by someone. This means that, at any price, existing holders have to decide, at the price in question, whether they are willing to continue to hold or willing to sell. The sum of the units that holders are willing to sell represents the “supply,” while the difference between the total quantity in existence and the sum represents residual (or reservation) demand. Total demand is given by the sum of residual demand and exogenous (or outside) demand. The market-clearing price is then determined at the point where total demand is equal to the fixed quantity in existence.
20
Valuation is always a forward-looking process. The current valuation of an asset bears a necessary relationship neither to the original cost of the asset, nor to the myros recovery charges that may already have been charged against past quasi-rents. The expectations that drive valuations can (and do) change so that an equity that seemed attractively priced yesterday need not be so today. Also, the myros recovery charged against quasi-rents in general bear little (if any) connection to an asset’s current prospects for generating quasi-rents. An asset can continue to generate quasi-rents long past the time that its original construction costs have been returned (via myros recovery charges) to the pool of fluid capital. The asset is still part of the economy’s produced means of production and has a value even though it may be carried on the books of the owning firm at zero.
26
3 The Macroeconomic Framework
The details are presented in Fig. 3.3. The fixed quantity of the good (or asset) in existence is given by the vertical spike at S. The “supply” function from S is given by ss, while the residual demand function, dd, is equal to the horizontal difference between ss and S. The total demand function is given by DD, which represents the sum of residual demand and outside demand as represented by the horizontal distance between dd and DD. The market-clearing price is accordingly p, for at this price every unit in S is in the hands of a willing holder. We now turn to the valuation of assets such as Old Masters. For simplicity concerning the basic ideas, assume that, with one exception, all money in an economy is used for transactions only, that titles to the stock of fluid capital are owned by firms, and that the only asset (again with one exception) held as a store of value is equities, which are owned by individuals. The one exception is an individual by the name of Rembrandt, who has built up a nest egg of savings that he holds in the form of money. Rembrandt has always been a house painter, but now decides that he is going to take some time to create “fine art” and do his painting on canvas. He finances this leisure activity from his holdings of money to purchase food and other essentials from the economy’s pool of fluid capital. Like Georgia in the Prologue, Rembrandt’s motivation at the start is simply to paint for his own enjoyment and to use his paintings to decorate his house. It is not long, however, before his friends and neighbors are badgering him to sell paintings to them for their own homes. Rembrandt finally agrees to sell a painting to a friend at a price that rather surprises him, since it is considerably in excess of what he could have earned had he spent the time it took him to paint the picture in painting houses instead. This gives Rembrandt the idea of turning his home into a studio and devoting all of his time to painting pictures for sale to others. Let it be said that Rembrandt was extremely successful in doing this, as his paintings were in great demand at ever-increasing prices. Enough of Rembrandt himself, what we want to do now is to inquire how the prices of Rembrandt’s paintings are determined and how they are able to maintain a value. To begin with, it is clear that the prices for Rembrandt’s paintings are arrived at through voluntary exchange between the buyers and Rembrandt. We need not spend much time on the supply price, for this will be determined by the greater of Rembrandt’s reservation demand price for his own paintings and the opportunity cost of his time. It is the buyers’ willingnesses to pay that are of most interest. On our assumptions, the wealth of buyers consists of their current flow of income plus the value of the equities they own. If we assume that Rembrandt insists on payment in money, then a portion of the current stock of money will be diverted to Rembrandt in payment for his paintings. If the money comes out of current saving, then initially the paintings can be viewed as any other good in the economy. The same is true even if the purchase of the paintings were to be financed out of existing holdings of equities although in this case it would be necessary to sell some equities to people with money to get the money insisted upon by Rembrandt. The immediate effect would therefore be downward pressure on the price of equities and hence an increase in their yield.
3.3 The Determination of Asset Values
27
Suppose, now, that Rembrandt dies so that the total number of his paintings in existence is fixed for all time. Because his paintings are objects of desire by many, they are frequently traded at prices which, in general, increase from one year to the next. This fact does not go unnoticed, and Rembrandt’s paintings come to be seen as a vehicle for transferring purchasing power over time. In short, they join equities as a second form of asset in the economy. Old Masters provide no direct yield in terms of income (except for flows of consumption enjoyment) but they nevertheless (not necessarily and not in all cases) can provide a positive yield over time through price appreciation. Why is this? What is the basis for Old Masters maintaining a value in the absence of a stream of income? Ultimately, the basis of value for a collectible (i.e., Old Masters viewed generally) is someone with a willingness to pay to own the object as an end in itself.21 For individuals, their willingness to pay clearly depends upon their individual wealth. For an economy as a whole, however, the valuation of Old Masters depends upon the pool of fluid capital evaluated in current prices. Old Masters, once they become so, can in general increase in value over time only because the capacity of the economy to generate income increases as a result of saving and investment. There is no other reason. Old Masters do not have an intrinsic value that is independent of an economy’s pool of fluid capital and its capacity to generate income.22 For valuations – seen simply as calculated present values – to be translated into actual prices, it is obviously necessary for those doing the valuations to have the wherewithal to translate desires into action. In other words, a willingness to pay, based upon calculations of present value, must imply an ability to pay in the event that the willingness to pay is at least as great as the price of the asset. The ability to pay, for any individual, is obviously constrained by the individual’s wealth. For an economy overall, however, the aggregate ability to pay is constrained by the pool of fluid capital evaluated in current prices.23 A modern economy obviously contains a large variety of assets of varying complexity. The principles that govern their valuations, however, are those which have been discussed. Consider, for example, the owner of vineyard who decides that she wants to sell the vineyard 15 years hence, but to own all produce from the property during the intervening 14 years. A contract is drawn up and then sold for a certain amount of money. The terms of the contract state that the contract can
21
In Chap. 12, we analyze such objects as examples of position goods. Pigou (1943, 1947), in his papers on the classical stationary state, included Old Masters with fiat money as giving rise to a wealth (or real-balance) effect in the event of a continuously falling price level. For reasons already noted, there can be no real-balance effect for fiat money (including gold and silver) and neither can there be a real-balance effect for Old Masters. For, as we have just seen, the valuation of Old Masters, as with the valuation of all assets, depends upon the pool of fluid capital valued in current prices. As prices fall, so too will the value of the pool of fluid capital evaluated in current prices. Real-balance effects will be discussed in more detail in Chap. 7. 23 This is yet another way of seeing that the pool of fluid capital valued in current prices imposes an upper bound on the aggregate value of assets in an economy. 22
28
3 The Macroeconomic Framework
always be sold at the option of the current holder, whoever that might be. While this contract is clearly a “forward” contract, its current value is determined in the same manner as any other current asset.24
3.4
Aggregate Demand and Supply
We now turn to aggregate supply and aggregate demand, which were introduced by Keynes in the General Theory and have been important concepts in macroeconomic theory ever since.25 In the present framework, aggregate demand and aggregate supply are defined as follows: Aggregate demand: Aggregate demand represents the total pool of purchasing power seeking to acquire goods. Aggregate supply: Aggregate supply represents the current stock of goods, valued in current prices, that is available to be acquired. Aggregate demand thus consists of a pool of purchasing power. No price level is implied, except that which is implicit in the price expectations that underlie the short-term loans funding current production. With aggregate supply, however, a price level is explicit. Indeed, as discussed in Chap. 6, aggregate supply is interpreted as implicitly defining the current price level. The pool of current purchasing power represents money that has been created by the banking system in response to demands of owners of produced means of production, and those intending to invest in new capacity. It also includes the money earmarked for consumption out of the current flow of income. Let v denote the period of production, which will be assumed, for simplicity, to be the same for every producer. Loans are then made for the purpose of financing the production of goods which will become available v time periods from the time that the loan is made. Assume also, for simplicity, that inputs (including labor) are purchased continuously. The goods that are currently available were “contracted for,” and their finance created, v time periods in the past. If income that is not saved is spent on consumption goods instantaneously with its receipt, this means that the pool of purchasing 24
The same principles apply to the valuation of all futures and forward contracts, options, warrants, swaps, etc. 25 Keynes, it will be recalled, defined aggregate supply and aggregate demand in terms of aggregate employment and aggregate expenditure. Aggregate demand, for Keynes, represented the amount of expenditure that producers expected to receive from employing a particular amount of labor, whereas aggregate supply represented the amount of expenditure that producers had to receive in order for that amount of labor to in fact be employed. Equilibrium was then assumed to occur at the point where aggregate demand and aggregate supply are equal. In contrast with Keynes, aggregate demand and supply in current-day macroeconomics is usually defined in terms of the level of aggregate real output and the general price level. The general price level did not figure in Keynes’s definitions because of his assumption that the price level was unaffected by output changes at less than full employment.
3.5 Macroeconomic Equilibrium
29
power currently confronting goods will include contributions from all vintages of money creation from v time periods in the past to the present. Under the assumptions that have been made, this pool can be approximated by the amount of money in existence (ignoring money held as an asset) at v=2 time periods in the past. On the average, accordingly, the expectations that drive the current availability of goods were formed v time periods in the past, whereas the expectations that create the current pool of purchasing power were formed only v=2 time periods in the past. In other words, the expectations that determine aggregate demand are formed v=2 time periods later than the expectations that determine aggregate supply. In view of this, it follows that aggregate demand and aggregate supply at time t can differ for two separate (although not necessarily unrelated) reasons: 1. Faulty forecasts of aggregate demand, v time periods in the future, on the part of producers (and their bankers). 2. Changes in expectations concerning aggregate demand (for v time periods in the future) between v time periods in the past and v=2 time periods in the past. With regard to above reason 2, a potentially inflationary scenario would be one in which expectations concerning aggregate demand are increasingly optimistic, while a deflationary scenario would be one in which expectations concerning aggregate demand are increasingly pessimistic. If all goods should be bought and sold in spot markets, which continuously clear, then the general price level would rise and fall continuously as aggregate demand exceeds or falls short of aggregate supply. Since most markets do not clear continuously; however, aggregate excess demand/excess supply will be accommodated, in substantial part, through changes in inventories or changes in unfilled orders. Prices for these goods will change only when excess demand or excess supply persists. Detailed discussion of the general price level and inflation will be deferred until Chap. 6.
3.5
Macroeconomic Equilibrium
In traditional fashion, it is natural to define a steady-state equilibrium of an economy in terms of equilibrium of aggregate demand and aggregate supply. As will be discussed in detail in later chapters, this concept of equilibrium encompasses the following conditions: 1. Realization of the expectations that drive aggregate supply. 2. Equilibrium in the market for the pool of fluid capital, in which the demand for fluid capital is equal to the supply. 3. A stable general price level.26 26
It will be shown in Chap. 7 that equilibrium of aggregate demand and aggregate supply and stability of the general price level are equivalent conditions.
30
3 The Macroeconomic Framework
While this definition of macroeconomic equilibrium is outwardly the same as that of Keynes in the General Theory, there are some important differences. Keynes repeatedly made the point that a dollar of investment, operating through the consumption function and the multiplier process, would eventually give rise to a dollar of new saving. For Keynes, the economy is not only in equilibrium when aggregate demand and aggregate supply (on his definitions) are equal, but also equivalently (ignoring other leakages and injections) when saving and investment are equal. However, in the present framework, equilibrium does not require that current saving and current investment be equal. In the Treatise on Money, Keynes allowed for saving and investment to differ, but this was in disequilibrium. In the present framework, saving and investment can be unequal in equilibrium as well. An equivalent way of defining macroeconomic equilibrium in the present framework is in terms of the equality of inflows into the pool of fluid capital with outflows. Inflows are represented by the sum of net saving (both personal and business) and myros recovery charges against revenues, while outflows are represented by investment in newly produced means of production and the “finance” of current production. Conventional analysis focuses on just saving and investment and thus ignores the inflows into the pool of fluid capital from myros recovery charges and the outflows from the financing of current production. When inflows into the pool of fluid capital equal outflows, there is clearly no necessity for saving and investment to be equal. The implications of saving being different from investment in steady-state equilibrium are discussed in Chap. 8.
Chapter 4
Interest and Money
One of the biggest controversies sparked by the General Theory concerned the determination of the rate of interest. Until the General Theory, the generally accepted view was that the rate of interest was determined in the capital market, defined in terms of the demand and supply of savings. The demand for savings was represented by the investment demand function, which depicted a negative relationship between investment and the rate of interest, while the supply of savings was represented by the savings function, which described a positive relationship between the interest rate and the amount saved out of income. The market was assumed to clear at the point where supply equals demand, thereby establishing investment, saving, and the market rate of interest. Keynes objected to this, for he saw the equality of saving and investment being determined by the Principle of Effective Demand. Hence, the rate of interest had to be determined in some other way. This other way for Keynes was by Liquidity Preference.1 Rather than viewing interest as a reward for not consuming (which is the view that Keynes attributed to the Classical economists), Keynes saw interest as the payment for giving up liquidity (i.e., the giving up of claims to money). For Keynes, accordingly, the interest rate was determined by the demand and supply of money rather than by the demand and supply of saving. Following publication of the General Theory, the two theories of interest became known as Liquidity Preference and Loanable Funds theories, and a heated debate was ignited, with Keynes on one side and Ohlin and Robertson, among others, on the other side.2 The rate of interest in the Loanable Funds theory was determined at the point where the supply of loanable funds, as given by the sum of current saving, dishoarding, and the creation of new money, is equal to the demand, as given by the investment demand for funds.
1 2
Keynes (1936, Chap. 13). See Keynes (1937b,c), Ohlin (1937), and Robertson (1937).
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_4, # Springer ScienceþBusiness Media, LLC 2010
31
32
4 Interest and Money
In my view, there is truth in both theories, not because they are equivalent (as has been argued by some neoclassical theorists),3 but because conceptually (as discussed in Chap. 3) there are two relevant rates of interest, a natural rate and a money rate. The Classical economists were correct in saying that the interest rate is determined in the capital market, but the capital market in question should refer to the entire pool of fluid capital, rather than just the inward and outward flows resulting from saving and investment. The natural rate of interest emerges from the interplay of demand and supply in this market. On the other hand, Keynes was correct in stressing liquidity preference as a primary determinant of the money rate of interest.
4.1
Factors Making for the Existence of Interest
Before going into the details of how interest rates are determined, it will be useful to discuss the factors responsible for the existence of interest in the first place.4 To begin with, it is clear that capital cannot exist in the absence of saving. At some point, there has to be a decision on the part of someone not to consume all of the product that is available. This can be seen as the first act of saving and the creation of the first stock of fluid capital.5 This stock could be carried over for consumption at a later time, or alternatively it could be used to fund the creation of a more productive method of production. If a decision is made to create a more productive method of production, this can be seen as the first decision to invest, the first creation of produced means of production, and (assuming that the new method of production lasts for more than one production period) the creation of the first stock of fixed (or sunk) capital. In such circumstances, it is not unreasonable that the decision to invest is made by the same person as made the decision to save, in which case the saving and investment decisions are one and the same (as per Smith, Ricardo, etc.). The pool of fluid capital grows through the flow of new saving and the return of “old” fluid capital through myros recovery charges against current production. The increase in the size of this pool represents, in most basic terms, economic growth. What are the incentives for this pool to grow – i.e., for capital to accumulate? The driving force is the fact that capital (in the form of produced means of production) is productive, in the sense that a given amount of labor working in cooperation with produced means of production and permanent resources will produce a greater output than the same amount of labor working with just the permanent resources. Or as Keynes put it, capital (again in the sense of produced means of production) generates a positive yield over its lifetime.6 3
See Hicks (1946, Chap. 12). There is nothing new in this discussion, for all of the points have been discussed by Fisher and others. 5 Cf. the young man’s decision to build up a stock of 10 days of bread to build a house in the “Prologue.” 6 See Keynes (1936, pp. 135–37). 4
4.2 Determination of Money and Natural Rates of Interest
33
Investment in produced means of production, however, requires waiting. Always, there is an initial period of waiting because produced means of production require time to construct before they can begin to produce.7 An additional amount of waiting may be required because the period of production for any single unit of output may be increased. Since people in general prefer present goods to future goods, those with claims to present goods must be offered a reward if they are to give up these claims in exchange for claims in the future. This would be the case even in the absence of uncertainty. The existence of positive yields from use of produced means of production is what allows this reward to be paid. Investment in produced means of production, however, is just one of the demands on the pool of fluid capital. There are two other demands: a demand for consumption in excess of current income (i.e., negative saving) and a demand for financing operation of the current capacity to produce (usually referred to as the demand for working capital). In most economies, the demand for working capital represents the largest demand on the pool of fluid capital, and monetizing fluid capital in response to this demand is one of the primary functions of commercial banks. Time preference means that, ceteris paribus, present goods are preferred to future goods. However, since time preference is not constant across individuals, those with lower time preference can be induced to exchange their claims to present goods with those with higher time preference for claims to future goods through payment of suitable rewards.8 The effect of such exchanges of current for future goods on the pool of fluid capital is either to reduce it (if the present goods would otherwise have been saved) or to leave it unchanged (if the present goods would otherwise have been consumed). In either case, it is clear that a desire to exchange future consumption for present consumption represents a demand on the pool of fluid capital. When there is a pool of fluid capital already in existence because of past saving, there is obviously no necessary connection between current investment and current saving. This point was made forcefully by Keynes in one of his 1937 Economic Journal papers defending the General Theory, when he states (paraphrased) that investment can be thwarted by a lack of finance, but never by a lack of saving.9 Keynes’s point was that, provided the banking system creates the finance for withdrawing goods from the pool of fluid capital, investment can proceed in the absence of (current) saving.
4.2
Determination of Money and Natural Rates of Interest
Let us now turn to the determination of the natural and money rates of interest. Consider, to begin with Fig. 4.1, which is similar to Fig. 3.2 in Chap. 3 and depicts the market for fluid capital. The vertical line labeled K represents the existing stock 7
Cf. Cassell (1903). See Fisher (1930). 9 Keynes (1937b). 8
4 Interest and Money Interest Rate
34 K
S r* r Dg + Dc + DI Dg
Dg + Dc
Stock of Fluid Capital, Saving
Fig. 4.1 Market for fluid capital
of fluid capital, including the inflow from myros recovery charges. The curve labeled s represents the inflow from current saving. Dg represents the demand for fluid capital for financing goods in progress. The horizontal distance between Dg and Dg þ Dc represents the exchange of future consumption goods for present consumption goods, while the horizontal difference between Dg þ Dc and Dg þ Dc þ DI represents the demand for fluid capital to finance investment in new produced means of production. The curve labeled Dg þ Dc þ DI thus represents the aggregate demand for fluid capital. In the absence of current saving, the market-clearing rate of interest would be r . However, with saving (as represented by the curve labeled s) in the picture, the market-clearing rate of interest will be r. In my view, it is compelling to call r determined in this fashion the natural rate of interest, for it represents the price that equates the demand for fluid capital with supply.10 As the figure is drawn, current saving is seen to add significantly to the stock of fluid capital. For wealthy economies such as the USA, current saving is small relative to K so that the market-clearing r will be much closer to r . Let us now bring money into the picture. In real life, the goods represented in the stock of fluid capital are not exchanged directly between holders and demanders but are transferred through the intermediary of money. The value represented by the stock of fluid capital is first monetized, loans are made, and the general purchasing power created is used to purchase the needed amounts from the unconsumed consumables and capital goods that constitute K. Loans are not denominated in units of fluid capital but in money, and interest accordingly is also reckoned in money. In approaching the question of how the money rate of interest fits into the picture, it will be useful to delve into what has always been considered one of the more opaque parts of the General Theory, namely, Keynes’s discussion of own
10
Readers are reminded once again that this concept of the natural rate of interest differs from the usual definition of the natural rate, which (per Wicksell) is the rate that equates investment and saving.
4.2 Determination of Money and Natural Rates of Interest
35
rates of interest. Keynes begins his discussion of interest in Chap. 17 by reminding readers that the money rate of interest “. . .is nothing more than the percentage excess of a sum of money contracted for forward delivery, e.g., a year hence, over what we may call the “spot” or cash price of the sum thus contracted for forward delivery” (Keynes 1936, p. 222). Keynes then goes on to say that, for every capital asset, there would appear to be an analog to the rate of interest on money – a “wheat” rate of interest, a “house” rate of interest, etc. For the “wheat” rate of interest, there is a definite quantity of wheat to be delivered 1 year hence which has the same exchange value today as 100 quarters of wheat for “spot” delivery. If the former quantity is 105 quarters of wheat, the “wheat” rate of interest can then be said to be 5% per annum. For every durable commodity, there can be said to be a similarly calculated rate of interest calculated in terms of itself. Keynes calls these rates of interest, own rates.11 Keynes noted that each capital asset, viewed as an instrument (or vehicle) for transferring purchasing power from the present to the future, possesses three different attributes in differing degrees as follows:12 1. Some assets produce a yield or net output, which he denoted by q. 2. Most assets, except money, suffer some wastage or involve some carrying cost through the mere passage of time, irrespective of their being used to produce a yield. Keynes denoted this wastage, or cost, by c and noted that the line between q and c is hard to draw, but that all that matters is the difference between the two, q c. 3. Finally, there is a third factor, which Keynes called the liquidity premium, which reflects the potential convenience for security that some assets possess in the power to dispose of them. Keynes denoted this liquidity premium by l. The total return of an asset, then, will be given by the sum of these three factors, q c þ l. Capital assets possess these three factors in differing degrees. Money has no yield (i.e., q ¼ 0), negligible carry cost (i.e., c ffi 0), but substantial liquidity premium, because money as an asset can be converted into money as medium of exchange instantaneously and without cost. Produced means of production have both yields and carrying costs, but in general little liquidity. An Old Master, on the other hand, has no direct yield (except for psychic enjoyment), often substantial carrying cost (insurance, etc.), and little liquidity. Keynes noted that investment in physical capital assets eventually leads to a reduction in their yields so that q c becomes negative. Since the liquidity premium for money dominates the liquidity premium for any other asset, the liquidity premium for money establishes a positive floor to the return on assets. This is the reason Keynes gives as to why the money rate of interest “rules the roost” over all other own rates of interest and accordingly
11 12
Keynes (1936, pp. 223–24). See Keynes (1936, pp. 225–28).
36
4 Interest and Money
establishes its critical importance in determining the general level of economic activity.13 As we have seen, for money to exist in any meaningful sense, it is necessary that an economy possesses a stock of fluid capital, which means that there has to have been prior saving. There does not have to be a stock of produced means of production for money to exist, but there does have to be a stock of unconsumed consumables. Money, in the circumstances, can be either commodity money or “trust” money or both. The former can exist because the commodity is widely desired as an end in itself, while the latter can exist as a “receipt” for goods in the pool of fluid capital.14 A banking system (broadly construed) greatly facilitates the monetization of the stock of fluid capital. Although the presence of a banking system is not necessary for money to be created, it can be done much more efficiently with one than without. As an economy develops and becomes more and more monetized, the banking system comes to play a larger and larger role in the functioning of the economy. Indeed, a sophisticated financial system itself is an integral part of an economy’s produced means of production. As an economy develops, finance comes to play an increasingly important role in determining the level and pace of economic activity. While the pool of fluid capital (measured at current prices) always sets an upper bound on the real stock of money, a wealthy economy has large stocks of both fluid capital and money and other financial assets. As a consequence, the connection between the two stocks becomes vague and ill-defined. Similarly – and more importantly – the connection between the money rate of interest and the natural rate of interest also becomes ill-defined, and the money rate of interest achieves immense importance. The money rate of interest achieves this importance because, in a monetary economy, goods are purchased and incomes are paid in money. An operator of produced means of production needing goods as inputs does not borrow these goods “on the come” directly (except through trade credit) but borrows money and purchases the goods with money. Similarly, wages are paid not in goods, but in money, which also has to be borrowed (even if the operator borrows from himself). And even if goods used as inputs are acquired on trade credit, payment is eventually in money, not finished goods. The availability of money, and the price at which it can be obtained, is thus of enormous importance. At this point, it would seem that the money rate of interest is a payment for obtaining money rather than (per Keynes) a payment for giving it up. Keynes, it will be remembered, identified three motives for holding money: transactions, precautionary, and speculative (which he associated with liquidity preference). The demand for money that has been discussed in the preceding paragraph is for 13
From the foregoing, it should be clear that the money rate of interest and the natural rate of interest (as defined here) bear no necessary relationship. Whether the two rates are equal in equilibrium is discussed in Chap. 6. 14 Cf. von Mises’s view that any form of money originates as commodity money. See von Mises (1934, p. 132). For other views as to how money emerges from a barter economy, see Clower (1967) and Kiyotaki and Wright (1989, 1991).
4.2 Determination of Money and Natural Rates of Interest
37
transactions. Keynes took the amount of money needed for transactions purposes as being determined by the level of economic activity. Specifically, in the General Theory, Keynes assumed the amount of money in existence as exogenous, determined by the monetary authority. The transactions motive has first claim on this stock, and what remains is then available to satisfy the precautionary and speculative motives. Keynes saw the precautionary demand as also being determined by the level of income so that the residual that remains is what is available to satisfy the speculative (or what I prefer to call the liquidity motive). Since this residual has to be held by someone, Keynes accordingly saw the money rate of interest as representing the price at which this stock of money was in the hands of willing holders. Since, in Keynes’s world, the alternative to holding money was bonds (specifically, consols), the price in question was the interest rate on bonds.15 In the General Theory, Keynes adopted the view that the monetary authority could control the supply of money so that the stock of money was taken as given. Also, he assumed that the only alternative to holding money as an asset is bonds. Real assets could also be held, but their yield, for reasons noted earlier, would be no greater in equilibrium than the liquidity premium on money. Thus, for Keynes, the important trade-off in determining the market rate of interest was the money rate of return on bonds in relation to the liquidity premium for money. Keynes’s assumption that liquidity preference derives from expectations concerning future movements in the rate of interest has received a great deal of criticism. Tobin in his classic 1958 paper reformulated liquidity preference in terms of behavior toward risk. Shackle, in The High Years of Theory, gives yet another alternative interpretation of liquidity preference, which does not involve a “bootstrap” basis for the interest rate, namely, that a loan of money involves the giving up of something certain in terms of liquidity in return for something inherently uncertain (repayment at a future date). Interest is the payment for giving up this certainty.16 In my view, the assumption that the money supply is exogenous is untenable. The money stock is created through monetization of the stock of fluid capital. Obviously, monetary authorities have influence – perhaps even a great deal of influence – through the standard instruments of monetary policy (including moral suasion), but there is much that those desiring claims to money can do to circumvent a particular thrust of monetary policy. For goods that can be purchased on
15
In one of his 1937 Economic Journal articles, Keynes (1937b) added a fourth motive for holding money, the “finance” motive, which he defined as a holding of money that is built up by businesses in anticipation of financing new investment. In my view, Keynes’s discussion of the finance motive is especially insightful because it deals directly with monetization of the stock of fluid capital (although just for the purpose of financing investment in produced means of production). Except for the Post-Keynesians (see, especially, Davidson 1978), however, the finance motive has never received much attention. Meltzer (1988), for example, dismisses it as of no importance and avers that Keynes did not accord it much relevance either. 16 See Shackle (1967, Chap. 15). I find this an attractive interpretation of liquidity preference although this is not to deny that the speculative motive can at times be a strong factor.
38
4 Interest and Money
IOUs (i.e., through trade credit), banks can create reserves through inducing depositors to shift their deposits from a category with a high reserve requirement to a category with a lower reserve requirement, etc. The time when liquidity preference would appear to be most operative is when a bank is trying to shift funds into an interest-bearing account. For it is at this point that a holder of money (which for now is assumed not to pay interest) must decide to give up a claim to money for an interest-paying asset, which has less liquidity. Inducing holders of money to acquire interest-bearing deposits is one of two ways that the banking system as a whole can, by its own efforts, increase its capacity to lend and therefore to increase the stock of money.17 The upshot of all this is that there is little question but that liquidity preference is a factor in determining the money rate of interest. Whether it is the only factor, however, is another matter. For this to be the case, it would be necessary that every point where the interest rate is a factor in balancing the demand for money with its availability be ultimately attributable to liquidity preference. This especially has to be the case at those points where money is actually created, by which I mean the points at which the pool of fluid capital is monetized. The standard way this is done is through business borrowing at commercial banks.18 The stock of money created by business borrowing is constantly being extinguished and renewed, and its size expands and contracts in response to the production needs of the economy. In the Economic Journal article referred to earlier, Keynes (1937b) clearly describes this revolving fund of finance, but his reference was to what he called a fourth motive for holding money, namely, the “finance” motive. As noted in footnote 15, however, Keynes’s focus in the finance motive was not the finance of production of consumption goods, but a buildup of finance for current investment. If the venerable Banking School’s terms of reference are broadened to include Keynes’s finance motive, then in my view the Banking School’s philosophy (i.e., the Real Bills Doctrine) provides a sound guide to monetary control. Even so, I believe that its ultimate focus on the value of current production is incorrect. Clearly, current production is what has to be financed, but the source for this finance is not the goods being financed but the pool of fluid capital. The pool of fluid capital being monetized is what enables the unconsumed consumables and intermediate goods that comprise the goods side of the pool to be drawn into current production. Most of the time,
17
The other way, obviously, is for banks to borrow from the central bank. Historically, money creation through business borrowing embodies what came to be known as the Banking School of Monetary Control (or equivalently as the Real Bills Doctrine). The premise of this school is simple and attractive. Banks are to make loans only for the purpose of financing current production, with the loans to be paid off by the proceeds from sale of the output, which is to say that the loans are self-liquidating. By restricting money creation to this form, the amount of money is carefully controlled – in essence, the value of current production providing an upper bound on the amount to be created – and risk (provided the bankers are adept at their jobs) is minimized (although obviously not eliminated altogether). For a discussion of the origins of the Banking School and the controversies, which surrounded it, see Schwartz (1987).
18
4.2 Determination of Money and Natural Rates of Interest
39
money creation on the basis of pending output will not cause any problems (in terms of inflation) because the pool of fluid capital will be sufficient to provision at current prices the current plans to produce. It is clear, however, that too much money can on occasion be created by this process as a result of businesses having too rosy expectations concerning the amount of output that can be sold – and bankers going along with these expectations – so that more money is created than there are goods available, at current prices, in the pool of fluid capital.19 The result will be inflation.20 So much for the moment for money as a medium of exchange. What about money as a store of value? A point repeatedly emphasized by Keynes in the General Theory is that a decision to save is a decision to postpone consumption from today until some time in the future. In a monetary production economy, since income is paid in money, a decision to save is initially a decision to hold money as a store of value. Yet, money is only one of many assets that can be used to transfer purchasing power from the present until some time in the future. Accordingly, once there has been a decision to save, there is a further decision as to what vehicle to use in pursuing the desired transfer of purchasing power. Keynes’s point in the General Theory was that, ceteris paribus, people would prefer to hold money because of money’s perfect liquidity. For people to give up this certainty, payment of interest is necessary.21 Let me now turn to what might seem an unusual question: In an “inside-money” world, can money be held as a store of value?22 What I have in mind with this question is the following. Assume for the moment that all money is bank money created by loans for the purpose of financing current production (both consumption goods and investment). This means, accordingly, that all money is dated, in the sense that the loans that created the money have specific dates of repayment. Assume, now, that some individuals decide to save a part of their income (which is paid to them in money) and in doing so decide to hold the saving in the form of money. If the loans that created the money, have to be repaid, where is the money to come from that is to extinguish the loans (since a part of it is now being held by savers as an asset)? The answer is that a portion of the original loans – specifically the portion which corresponds to the money being held as an asset – has to be rolled over, so that the money being held as an asset is not extinguished. Clearly, for banks
19
Cf. the discussion by Keynes of borrower’s and lender’s risk in Chap. 11 (p. 144) of the General Theory. See also Minsky (1975) and Chaps. 15 and 16 below. 20 The foregoing illustrates in yet another way the fact that the real value of the stock of money (viewed in terms of means of exchange) is bounded by the pool of fluid capital valued at current prices. 21 Keynes saw bonds as the only alternative asset to money but this is obviously not the case. An individual’s portfolio decision is not just between money and bonds but between money and a wide range of assets, both financial and real. Economists who have modeled this portfolio decision in a general equilibrium framework include, among others, Tobin (1969) and Friedman (1974). 22 The standard reference on the distinction between “inside” and “outside” money is Gurley and Shaw (1965).
40
4 Interest and Money
to be willing to do this, there has to be the prospect of an increased stream of revenue (valued in current prices) foreseen by businesses and accepted as valid by banks. Otherwise, banks would not be willing to increase the total quantity of loans. In a fractional reserve banking system, the additional loans that are needed to fund the stock of money being held as an asset requires new reserves. These new reserves can be provided by the central bank or, alternatively, they can be acquired by inducing individuals holding money as an asset to give up some of their liquidity. In the absence of reserves provided directly by the central bank, it would thus seem that Keynes’s liquidity preference is indeed the margin at which the money rate of interest is determined, even in a world in which there are many other forms and types of assets. This is because the liquidity premium for money provides a floor to the asset rate of return.23 On the other hand, suppose that the additional reserves needed to sustain an asset demand for money are provided by the central bank. How is the money rate of interest determined in this situation and what role, if any, does liquidity preference play? The easiest case to deal with is a change in the reserve ratio. If the reserve ratio is reduced, reserves are released, and banks can make additional loans at the existing money rate of interest. Reserves for loans do not have to be attracted from existing holders of money as an asset by paying a higher liquidity premium. What about open-market operations? To analyze these, it will be assumed that the central bank deals only in government debt. This is not a necessary assumption, but it is obviously realistic and can be viewed as abstracting from all risk and uncertainty relating to default. If the central bank wishes to increase the reserves of the banking system, it can do so by purchasing government bonds in the open market. Ultimately, this increases deposits of banks at the central bank, and therefore reserves, thereby laying the basis for additional loans and hence the creation of money. The purchase of bonds in the open market leads to an increase in their price and hence to a decrease in their yield. The increase in reserves means that additional loans can be made with no upward pressure on the money rate of interest, because those already holding money as an asset do not have to be bribed by higher payments in order to give up liquidity. While the purchase of bonds will reduce the bond yield, the yield cannot fall below the pure liquidity premium of the marginal holder of money as an asset. Liquidity preference in this case is active only to the extent that it provides a floor for how far the money rate of interest can fall. Finally, there remains borrowing by banks from the central bank. A decision by a bank to borrow from the central bank reflects a conclusion that this is the most economical way to acquire reserves. Use of the rediscount window would thus seem to be the only circumstance in which the central banks can fuel a creation of money at a money rate of interest that is lower than the pure liquidity premium of money. This would be the case if the rediscount rates were so low that banks could lend at a
23
Consequently, for the point that he was wishing to make, Keynes would seem to have been not only justified but also logically correct in assuming bonds to be the only alternative asset to money.
4.3 A World with Fiat Money
41
rate that is below that the banks would have to pay in order to overcome the marginal liquidity preference. To summarize this discussion on the determination of the natural and money rates of interest: 1. The natural rate of interest is seen as representing the price, which clears the market for the pool of fluid capital. This is determined by the interaction of the demand for fluid capital (comprised of the demands for investment in produced means of production, finance of current production, and consumption in excess of income) and the supply of fluid capital (comprised of the stock of fluid capital plus the inflow from saving). 2. The money rate of interest is the own rate of interest on money, which because of the pure liquidity premium on money (in conjunction with the other characteristics of money) sets a lower bound to all other asset rates of interest. 3. In an “inside-money” world, money is created through bank loans negotiated for the purpose of financing current production of consumption goods and investment in produced means of production. The interest rate on these loans can be viewed as the money rate of interest. The level of this rate is determined ultimately by the price that banks must pay to holders of money as an asset to free up the reserves needed to finance (in a growing economy) an everexpanding pool of loans. This price is determined by marginal liquidity preference. The money rate of interest is thus seen as the price of creating new means of payment (in an inside-money world), but its level in turn is seen as depending upon the pure liquidity premium of money held as an asset. 4. All other returns on assets (viewed as vehicles for transferring purchasing power from the present to some time in the future), both financial and real, are related through portfolio adjustment to the money rate of interest – and ultimately to liquidity preference.
4.3
A World with Fiat Money
The discussion to this point has assumed an inside-money world. We now turn to a world in which there is government (or fiat) money as well. The government can create fiat money directly by running the printing press or indirectly by selling bonds to the central bank. Money created in this way is in general perfectly substitutable with bank money, but unlike bank money, it is not dated at the time of creation. Among other things, this means that increases in the demand for money to hold as an asset, which may arise out of current saving, can be accommodated by an accumulation of fiat money without putting any upward pressure on the money rate of interest. On the negative side, however, the power of the government to create money directly also means that, unlike for bank-created money, there is a form of money creation that can avoid the discipline imposed by the pool of fluid capital.
42
4 Interest and Money
Since businesses form their plans for production on the basis of current and expected flows of income, a well-functioning banking system will in general not over-monetize the pool of fluid capital. But this is not the case for government, for the government can create money without regard to the pool of fluid capital. If too much money is created, the obvious result will be inflation. Specifically, let us consider the case in which the creation of fiat money causes expectations of inflation by those holding money as an asset. In this situation, the carrying cost of holding money increases from what is negligible in ordinary circumstances to an amount that is at least as large as the expected inflation. Money, in this situation, will still have a pure liquidity premium, but the overall yield on money is reduced by the expected inflation. What now will happen to the money rate of interest? In this situation, it would seem that the own rate of interest on money would cease to “rule the roost,” for the overall return on money will no longer be held up at the pure liquidity premium but will fall below the liquidity premium because of the now (inflation-induced) positive carrying cost. Indeed, the overall return on money can now be negative. However, because the expected inflation can be factored into the prospective yield on real assets, the return on real assets can continue to be positive. The asset whose own rate of interest is expected to be highest will become the standard bearer in this situation, and the money rate of interest will become equal to this own rate of interest plus the expected inflation. In an inflationary environment, however, the standard bearer in general will vary from one time period to another. First, one real asset will be the preferred store of value, then another, and so on and so forth. The upshot is that inflation, among other things, robs a monetary economy of a basic certainty and stability by eliminating money as a store of value. Nevertheless, money continues to function as a medium of exchange and indeed is needed in ever larger quantities. Creation of these ever larger quantities requires an inflation premium to be added to the money rate of interest in order to keep banks whole in terms of the price level that is expected to prevail at the time that loans are repaid. Since inflation is also factored into the expectations of businesses, the borrowers will in fact be willing to pay the inflation premium.24 In this way, the money stock, now functioning only as a medium of exchange, always adjusts to a real value that is determined by the stock of fluid capital.25
24
Cf. Fisher’s distinction between the nominal and real rates of interest, in which the nominal rate differs from the real rate by the expected rate of inflation. 25 The foregoing suggests that the monetarist view that inflation always follows the creation of money is not true as a general proposition. Certainly, the monetarist conclusion is valid with respect to the creation of fiat money but not with respect to the creation of bank money. For with bank money, the money is created in anticipation of inflation, so that it is expected inflation, which determines how much money will be created. Bank money, once created, can (and usually will) ratify the inflation, but its creation is not the initial cause of the inflation.
4.4 The Concept of Velocity and the Demand for Money
4.4
43
The Concept of Velocity and the Demand for Money
The standard approach to the demand for money is in terms of the demand for real balances – i.e., the demand for a real stock of money. The usual point of departure is Marshall’s cash-balance equation: M ¼ ky;
(4.1)
where M is the stock of transactions balances, y is current income, and k is the reciprocal of velocity. The usual interpretation of velocity is that it is primarily an institutional datum, determined for the most part by the payment habits of the economy. There is obvious truth in this, especially as regards the average transactions balances that are held by households and businesses related to the payment of wages and salaries. Velocity, however, is both more and less than this; more in that one of its main determinants is not focused on, and less in that (in reciprocal form) it is more a consequence of the demand for money than a determinant. The purpose of this section is to elaborate upon these statements. As was noted earlier, most discussions treat money as something that is apart from production and the generation of income. In general, the stock of money at any point in time consists of two components, fiat money in the hands of the public and bank money (which we can take to consist of all deposits subject to transfer by check).26 The amount of fiat money in the hands of the public can indeed be treated as a quantity that exists independently of the current level of economic activity, by which I mean that it has not come into being because of current economic activity. Fiat money, at the time that it comes into existence, is not dated for extinguishing. This is not the case for bank money, however. Bank money is dated for extinguishing, in the sense that the loans that create it become due and are expected to be paid off. The amount of bank money in existence at any point in time does not exist independently of the level of economic activity but is part and parcel of the process that determines the level of economic activity; the desire and willingness to produce is what gives rise to the amount of bank money in existence in the first place. The bank money component of the money stock is thus not a stock that is constantly turned over; rather, its quantity is constantly being created and destroyed. Fiat money in the hands of the public largely serves retail trade, and the same dollar can pass through several hands even in the course of a day. It accordingly makes sense to speak of velocity with respect to fiat money. Velocity with respect to bank money, however, seems to me to be a highly artificial concept. In most cases, the length of a commercial loan will be related to the period of production for the recipient of the loan. Production loans in agriculture, for example, are usually of longer duration than loans in retail and wholesale trades. Relating velocity to just 26
Travelers checks (which, with the advent of ATM machines, is no longer of much significance) and unutilized credit card lines will be ignored.
44
4 Interest and Money
the payment habits of the economy would therefore seem to overlook the contribution of the average period of production as measured by the average length of a commercial loan. Ceteris paribus, more bank money will be created for a longer period of production than for a shorter period of production, which means that velocity will appear to be larger, the shorter the period of production.27 Businesses and households are usually depicted as demanding certain stocks of money, and either the monetary authority accommodates these demands or else interest rates adjust to equate the demands with available supply. Businesses demand money because they have to finance current production and investment. Households, on the other hand, demand money because they need to finance current consumption and financial transactions and also because they want to hold money as an asset. However, there is an important difference in the way that money is obtained by businesses and in the way that it is obtained by households. Businesses acquire money initially as loans and then again through sales receipts, out of which the loans are repaid. Most of the money acquired by households, in contrast, is obtained as income. Households in receipt of income face two decisions: (1) how much is to be spent on consumption goods and (2) of the amount saved, how much is to be held as money. The former, in conjunction with the frequency with which income is received, determines household demand for transactions balances, while the latter adds to household demand for money to hold as an asset. The conclusion at this point is that both business and household demands for transactions balances are in great part passively determined; business demand as a consequence of current decisions to produce and to invest in new capacity, and household demand as a consequence of decisions of how much to consume out of current income. Sequentially, however, the former comes first, for business demand for new bank loans creates most of the transactions balances that are used by both businesses and households. Because of this, it seems to me that the point of departure in analyzing the demand for money should always be the demand for bank loans. Household demand for transactions balances can still be meaningfully related to current income,28 but in focusing on business demand to begin with one does not lose sight of the origin of the money that is being demanded.29
27
At the time these words were first written, “e-business” on the Internet had already emerged as a major force in the way that firms do business with one another. Not only does the Internet allow firms to connect directly with customers but it also allows them to connect directly with vendors and suppliers on a real-time basis. Purchase orders can be executed more quickly and economically using the Internet and payment is more rapid. Periods of production are thereby reduced, resulting in a more rapid turnover of business bank loans and a slowing in the rate of growth of the primary money supply. 28 As well as to short-term interest rates a la Baumol (1953) and Tobin (1956). 29 A useful parallel can be drawn between the discussion in this section and Keynes’s discussion in Chap. 3 in the Treatise on Money of the three predominant types of bank deposits. The three types of deposits in question were referred to by Keynes as income, business, and savings deposits. The first two represent the transactions balances held by households and businesses, whereas savings deposits represent money held by households as an asset. At the time, Keynes’s orientation was still very much in the Cambridge tradition of the Quantity Theory so that his discussion is largely concerned with the volumes of deposits that are demanded in relation to volumes of transactions, with an eventual focus on the price levels relevant to each of the “circulations.”
4.5 Power of the Monetary Authority
4.5
45
Power of the Monetary Authority
As has been noted at several points in these pages, a major failing in monetary theory, in my opinion, is lack of attention to the reasons why money is created. One of the biggest problems, as mentioned in the last section, is the tendency to treat money as a stock that somehow exists independently of the level of economic activity.30 I want to turn now to the power that the monetary authority has to affect monetization. In the USA, the central bank has three entry points: (1) it controls the amount of primary money available to the banking system; (2) it sets the discount rate; and (3) it can exercise “moral suasion.” In a fractional reserve banking system, primary money (which consists of cash held by banks and bank deposits at the central bank) represents the reserves of the system. In the USA, the market interest rate that the central bank is most able to influence directly is the Federal Funds Rate, which is the rate that banks pay to borrow reserves from one another overnight. When the Federal Funds Rate is lower than the discount rate, this price represents the marginal cost of reserves to the banking system. Obviously, the central bank can control the level of the discount rate, but it cannot control whether banks actually use the rediscount window (except during times of tightening when it can warn banks against overuse). Through the discount rate and its ability to control the amount of excess reserves in the banking system, the central bank can exert strong influence on short-term interest rates, which is to say rates on 60- to 90-day commercial loans. On long-term rates, the central bank’s influence is much less. Indeed, on very long-term rates, its influence would seem to be confined to whatever effects it might be able to exert on expectations. As has been discussed, long-term rates are formed in what we ordinarily think of as the capital market, for it is in this market that the claims on the pool of fluid capital are exchanged for bonds and equities – i.e., where liquid claims associated with current and past saving are exchanged for claims against the earnings of the stock of produced means of production. Although, in principle, the central bank might be able to exert some influence on long-term rates by buying or selling longterm government bonds, its policy has never been to do this.31 And even if it did, it is not clear that it could have much effect, because long-term rates are so sensitive to expectations of inflation, which much of the time are beyond the control of the central bank. In essence, therefore, what the central bank is able to influence is the terms on which monetization of the pool of fluid capital proceeds. It does this through the 30
A good part of the post-Keynes fault for this can be attributed to Keynes himself because of his assumption in the General Theory that the money supply is controlled by the Monetary Authority. In one of his 1937 papers in the Economic Journal defending the General Theory, Keynes (1937b) clearly displayed understanding of the basic endogeneity of the money stock, but he restricted attention to what he called the “finance” motive for business holdings of money. He was very explicit in describing the money demand associated with this motive as constituting a revolving fund. He failed, however, to extend this reasoning to the whole of bank-created money. 31 Or at least not until the financial meltdown of 2007–2008.
46
4 Interest and Money
volume of reserves that it allows the banking system to have and by setting the price at which banks can augment their reserves by borrowing through the rediscount window. Banks, however, can also increase their reserves by inducing the public to part with money that is being held as an asset. Indeed, during periods of monetary stringency, this may be the only source that banks have for acquiring reserves. In this situation, accordingly, both money and natural rates of interest are determined purely by liquidity preference.
4.6
The Commercial Paper Market
The discussion to this point has implicitly assumed that current production is financed through bank loans. Clearly, this is not entirely the case for many companies that acquire short-term financing in the commercial paper market rather than through bank loans. Major participants on the buyer’s side in the commercial paper market include banks, money market funds, and corporations with either a temporary or permanent surplus of money. The funds supplied represent current and past savings. For corporations the savings in question reflect myros recovery charges and retained earnings, while for households they represent decisions to hold assets in the form of near monies. Banks participate in the commercial paper market as both buyers and sellers. As buyers of commercial paper, banks may simply be recycling the savings of their depositors. However, if the paper bought is in turn discounted at the central bank, the result is a creation of new money. On the other hand, as sellers of commercial paper, banks are using this market as a source of reserves. The commercial paper market can be viewed as the short-term counterpart to the private placement market for investment in produced means of production. As the commercial paper market increases in importance, conventional short-term loans at commercial banks become less important in providing finance for current production. This is undoubtedly a reason why commercial banks in the USA moved strongly in recent years into mortgage lending, consumer loans, and the provision of other forms of financial services. One also can wonder, however, whether the increasing amount of current production in the USA being financed through the commercial paper market is not a reflection of the greatly increased fiat money made available by the large federal deficits during the 1980s and first half of the 1990s. If so, then fiat money is, in effect, substituting for bank money in the monetization of the pool of fluid capital. The fiat money in question is not created directly but rather indirectly through the purchase of new government debt by commercial banks. The government disburses the funds generated to the public in payment for goods and services. To recipients, money created by the sale of bonds to commercial banks is no different than any other money. What is not spent for consumption will initially be held as money as an asset and can therefore become available to the commercial paper market. Since the money involved has been created through the sale of bonds,
4.7 Some Notes on Monetary Policy
47
it is not dated in the sense that a short-term bank loan to a business or individual is dated. The only way that it can be extinguished is through a net reduction in government debt, but this cannot happen so long as deficits persist. The money in question has accordingly become de facto fiat money and can provide a permanent source of funds to the commercial paper market.32
4.7
Some Notes on Monetary Policy
An insistent theme throughout this book is that money is endogenous and its creation is part and parcel of the working of a monetary production economy. In most circumstances, money is created for the purpose either of financing current production or the initial finance of investment in produced means of investment. In the USA, most new money created takes the form of demand deposits arising from loans at commercial banks. Since money is destructed by the repayment of old loans, the most important indicator of money creation at a point in time will accordingly be net new borrowing at commercial banks. If to this is added the net increase in credit card debt and the net increase in currency in the hands of the public, then one should have a pretty good fix on the increase (or decrease) in the stock of money for use as a medium of exchange. The foregoing accords well with measuring the stock of money at a point in time in terms of the traditional M1, defined as the sum of currency in the hands of the public, all deposits subject to transfer by check, and travelers checks. M1 is probably about the nearest that one can get to a measure which, in principle, represents the pool of purchasing power constituting aggregate demand (as aggregate demand has been defined in this book).33 However, for a number of years, M1 has been deemphasized by policymakers as the measure of the money stock to be used for policy purposes in favor of the more inclusive measures M2 and M3. The idea seems to be that what is most important to the short-term behavior of an economy is the amount of ready liquidity that is available, and M2 and M3, which includes time and savings accounts and certificates of deposit, are better measures of this liquidity. In my view, however, the focus on M2 and M3 for policy purposes misreads the reasons why households and businesses hold interest-bearing near monies. In most 32
It becomes de jure fiat money at the point when the central bank purchases the bonds in the open market in order to provide the banking system with more reserves. 33 Even so, it is still almost certainly far from a perfect measure. Aggregate demand, as it has been defined in this book, represents the pool of purchasing power confronting the currently available supply of goods and services and will consist of money that is earmarked for financing current production and investment in produced means of production plus money earmarked for consumption in excess of income. Because a significant portion of currency in the hands of the public is outside of the country, and many travelers checks are held as precautionary reserves, M1 will in general probably overstate this pool of purchasing power.
48
4 Interest and Money
cases, these deposits and certificates represent the outcomes of portfolio choices that are removed from the initial savings decisions that give rise to the claims that were used to acquire the deposits in the first place. For holders with high liquidity preference, time and savings deposits and certificates of deposits in essence represent risk-free idle balances that earn interest. The balances may be idle for only a short period of time, as with businesses holding temporary excesses of cash, or the balances may be idle for a long period, as with many older households that feel more comfortable holding a significant part of their assets in near cash. I do not mean to imply by this that policymakers are wrong in paying attention to more inclusive measures of money, only that these should not be the exclusive focus. The events during the summer and early fall of 1998 provide a good example of the potential dangers of a narrow focus on broad monetary aggregates. The Russian devaluation in August 1998, in conjunction with the continuing financial problems in the far east, created so much uncertainty that there was a stampede away from risk in international financial markets. The USA was viewed as a safe haven, and in particular there was a rush into US government securities. Yields on the latter fell, while – in response to the increased uncertainty – yields on nongovernment long-term securities rose. The M2 and M3 aggregates also rose, as many investors reacted to the increased uncertainty by shifting assets from stocks and bonds into thrift accounts and deposits. During that time, if monetary policymakers had just focused on M2 and M3, they probably would have been led to believe that an incipient inflation was at hand. However, this was not the case, as the movement into interest-bearing near monies (as into US Treasuries) was a response to uncertainty rather than preparation for a consumption binge. In my view, rather than concentrating on the behavior of the M2 and M3 aggregates, the quantities that monetary policymakers should most focus on are commercial bank loans to business (including commercial paper, which is discounted at the central bank), installment credit loans to consumers (including credit card loans), the states of business and consumer confidence, and changes in asset values in relation to the growth in real income and output. The last is particularly important to monitor because if asset values as an aggregate should begin rising faster than the increase in real income and output, this is almost certainly an indication that the banking system is creating too much money. And, as will be emphasized in the next chapter (as well as in Chaps. 15 and 16), the contingency especially to be guarded against are loans in which assets are being mortgaged in order to buy other assets. The states of business and consumer confidence are important because these states reflect the expectations that drive current production and investment in new produced means of production. A growing economy with a stable price level requires a combination of expectations that results in the creation of a “right” amount of purchasing power, namely, an amount equal to the goods contained in the pool of fluid capital evaluated at current prices. Commercial bank lending is obviously key to the creation of this “right” amount of purchasing power; hence, the importance to policymakers of keeping a close watch over the amounts and types of loans that are being created.
Chapter 5
Production and Investment
The focus in this chapter is on the role of capital in production and the relationship between demand, short-run marginal cost, and investment. The point of departure is the simple truism, noted in Chap. 1, that current demand has to be served from current capacity, which is fixed. Current production decisions, accordingly, involve the choice of how much of current capacity is to be utilized. This depends upon expectations of current demands in relation to current short-run avoidable costs of production. Current investment decisions, in contrast, depend upon demands expected in the future in relation to the expected short-run avoidable costs of operating the capacity, which is expected to be available for serving those demands. In the framework presented in this chapter, there is a short run of a traditional sort. Specifically, the short run is defined in terms of the current production decision period using the plant that is currently in place. In general, there is no problem in identifying this short run with the short run of Marshall. However, there is no Marshallian long run, in which production structures are allowed to adjust optimally to demands. The long run in this chapter is defined in terms of a real-time long run, in which firms, through their current investment decisions, are able to adjust production structures for serving expected future demands. The long run, accordingly, is seen as consisting of two horizons: 1. A construction horizon, which represents the length of time, beginning from scratch, that a firm requires to bring new capacity into production in an orderly way. 2. An investment horizon, which represents the length of time, once the capacity is in operation, that the fluid capital expended in its constructed is to be recovered.
5.1
Capital and Production
I shall begin with the relationships between capital and production. It is not meaningful in my view to treat capital sunk in produced means of production as an input into production in the same manner as labor. Machines, buildings, etc., L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_5, # Springer ScienceþBusiness Media, LLC 2010
49
50
5 Production and Investment
obviously have a physical reality, but it makes more sense, in my opinion, to see the stock of produced means of production as combining (or cooperating) with permanent resources and labor to determine the capacity to produce and the potential to generate income. At any given time, this capacity to produce is not a variable, but a constant. What is variable is the output that is to be produced. The standard neoclassical way of expressing production possibilities is via an aggregate production function Q ¼ f ðK; LÞ;
(5.1)
where K denotes “capital” inputs and L denotes labor. Assuming appropriate continuities, marginal physical products are obtained through differentiation. In my view, the capacity to produce at any time t is better expressed as QðtÞ ¼ F½LðtÞ; t;
(5.2)
where F represents the existing structure of production. With this framework, one can speak about the marginal productivity of labor, but not of the marginal productivity of physical capital, since physical capital is embodied in the “shape” of F, and therefore is fixed. Time t is included as an argument in F to remind us that the “shape” of F changes through time as a result of investment and retirements.1 Let me now turn to the matter of how one might go about defining substitution between capital and labor. During the Cambridge Capital Controversy of the 1960s and 1970s, the standard way of approaching this question was through a comparative static analysis involving the comparison of alternative stationary states. Accordingly, let a steady-state reparameterization of the function in expression (2) be given by Q ¼ FðL; aÞ;
(5.3)
where a denotes a particular stock of produced means of production. If we now differentiate this expression with respect to a, it is tempting to interpret the resulting partial derivative as the marginal product of “capital,” although only in the sense of the added steady-state output that would be forthcoming from the addition of another “unit” of produced means of production. While this exercise may have some formal validity, it does not, in my view, have any real-world meaning. For it assumes that the embodiment of produced means of production in F can be parameterized, and it is not clear, as a practical matter, that it is possible for this to be done. It should be noted that the physical capital embodied in F is not the fixed capital defined in Chap. 2 (which is net of myros recovery charges against revenue), but rather the produced means of production that are in place at t. The two differ because myros recovery charges usually bear little relationship to loss of ability to produce. 1
5.1 Capital and Production Fig. 5.1 Short-run marginal cost curve
51 S Φ*
Short-Run Marginal Cost
Q
As has been noted, investment and current output is funded by the pool of fluid capital. Current output accordingly depends every bit as much on the pool of fluid capital as it does on the input of labor, which means that the output function in expression (5.2) should be written as QðtÞ ¼ F½LðtÞ; KðtÞ; t;
(5.4)
where KðtÞ is understood to represent the stock of fluid capital.2 A key concept in determining the level of current output is short-run marginal cost. “Short-run” in this context will be defined in terms of some relevant short-term period of production under the assumption that the capacity to produce is fixed. This upper limit to production can be represented as a vertical spike, as F in Fig. 5.1. Short-run marginal cost will be defined as the avoidable cost of producing one more unit of output. The short-run marginal cost curve then describes how marginal cost changes as the utilization of F varies from 0 to F . For the usual reasons, one can see this curve as rising with Q, and especially steeply as Q approaches F . To be included in short-run costs are only the out-of-pocket expenditures of producing output. Obviously, this will include direct expenditures for labor and materials, including expenditures that do not vary with output once the decision to produce has been made. An engineer “babysitting” a telephone switch would be an
2 I am not aware that fluid capital has previously been viewed as a “factor” in current production, but it is clearly an important element. Production requires the purchase (and therefore the finance) of material inputs and labor, payments of rent, etc. Some of the classical economists (Ricardo, in particular) viewed capital as providing advances on production, but it is not clear that the fund involved was seen as separate from the stock of produced means of production. In any event, it is clear that production can falter from a lack of “finance” for goods-in-process. Indeed, one can imagine a circumstance in which so much of the pool of fluid capital goes into the construction of the capacity to produce that not enough remains to finance current production. Plants stand idle, because there’s no fluid capital to finance their operation. For an analysis of how taking into account the need to finance current production can cause the investment function to slope upward, see Appendix B.
52
5 Production and Investment
example of the latter. Capital expenditures, as usually understood, are not included in short-run marginal cost. No depreciation is included, nor user costs in the sense of Keynes. However, all expenditures necessary for the operation of plant and equipment (such as oil and grease) are to be included. The short-run marginal cost curve is a key instrument for planning the level of current production, because it provides a floor to the price (or in the present context, the revenue) that must be obtained from the sale of output. Prices below the short-run marginal cost curve would leave producers with literal out-of-pocket losses. However, once the position of the short-run marginal cost curve is known, the actual revenues obtained will depend upon demand conditions. If (as is implicitly assumed to this point) output is sold either in a spot market or by contracts whose durations do not extend beyond the period of production, capital charges (i.e., interest and myros recovery charges) and other financial obligations of firms must be charged against the quasi-rents generated by revenues in excess of short-run costs. On the other hand, if output is sold under contracts that extend beyond a single period of production, contract prices (and therefore revenues) will include some capital charges. The extreme would be a contract which extends over the full planned life of the underlying produced means of production, in which case the contracted revenues would include all of the capital charges. This is the only situation that calls for long-run marginal cost being the floor to price. Current decisions to produce are thus determined by the relationships between short-run marginal cost and expected demand. The capacity to produce is already in place, and the only question is how much of the capacity is actually to be utilized. Planned production, however, is one thing, while actual execution is something else. This is because production requires “financing,” which draws upon the pool of fluid capital, initially in terms of money (as a means to transfer goods) and then ultimately in terms of goods.
5.2
From Production to Investment
Investment converts fluid capital into fixed (or sunk) capital and adds to produced means of production. By adding to produced means of production, investment adds to the capacity to produce and to the potential to generate income. As with current production of consumption goods, investment has to be “financed” out of the pool of fluid capital. A common misconception is that investment is financed by saving, but this is not necessarily the case. For saving, whether business or personal, is just one of the flows into the pool of fluid capital. A dollar of fluid capital is a dollar of fluid capital no matter how it gets into the pool. And, as we have seen, investment can be financed, so long as the pool is not empty, even if current saving is zero. Keynes emphasized that, in general, investment is undertaken by different people and for different reasons than those who save. Keynes was not the first to note this, but no one before him (except possibly Marx) attached as much importance to the fact. Individuals save out of current income because they want to
5.2 From Production to Investment Fig. 5.2 The investment decision
53 S
D
Φ*
Ps Pf P0 D Capacity
transfer income from today to some (usually indefinite) time in the future. Businesses invest in produced means of production because they foresee an opportunity to make a profit. At the time of Adam Smith, these were often (or even usually) the same people, but this ceased being the case a long time ago. A simplified view of the investment decision is described in Fig. 5.2. Let F denote the existing capacity to produce current output, and let DD represent the current demand (or willingness-to-pay) to utilize this capacity. The market for capacity is obviously cleared at a price per unit of capacity Ps . Ps thus represents a spot price. The upward-sloping curve that begins at P0 from F represents the short-run supply curve of the capital-goods industry – i.e., the supply curve for newly produced means of production. Any point on s represents the price at which the capital-goods industry is willing to supply (over some relevant period of time) the corresponding amount of new capacity measured from F . The (new) capitalgoods market will clear at a price of Pf , with investment in new capacity of I. Whereas Ps represents the spot price of existing capacity, Pf can be interpreted as the forward price for new capacity.3 Note that for investment to take place, it is necessary that the spot price be greater than the minimum price that firms in the capital-goods industry have to have in order to begin producing new produced means of production. Let us now delve behind the investment decision depicted in Fig. 5.2. In approaching this, it is important to keep in mind that the curve DD represents the willingness-to-pay for holding capacity to produce as a function of the unit price of that capacity. It does not represent an aggregate demand function, defined as the demand for output from the capacity as a function of the price of output. What really needs to be described is what goes on in the neighborhood of the marketclearing spot price Ps . Consider, accordingly, an investment (as contemplated by some individual or business), where investment in this context is taken to refer to a stream of prospective yields from a particular configuration of produced means of production.4
3 4
Davidson (1978) refers to this price as the forward flow-supply price. Cf. Keynes 1936, p. 136, passim).
54
5 Production and Investment
Following Keynes, let q1 ; . . . ; qn denote a stream of prospective yields over an investment horizon of n periods. Specifically, let q i ¼ Ri C i ;
(5.5)
where Ri denotes the revenues from sale of output in period t and Ci denotes the cost (defined as the short-run avoidable cost) of producing these revenues. The willingness-to-pay for this investment (i.e., stream of prospective yields) will be x¼ ¼
n X
qi
i i¼1 ð1 þ rÞ n X Ri C i i i¼1 ð1 þ rÞ
;
(5.6)
where r denotes the discount factor. A necessary condition for the investment to be undertaken through the purchase of existing capacity is for x > Ps . This is in the spot market for produced means of production. If x is less than Ps , but greater than Pf , the investment might be undertaken through the purchase of newly produced means of production. The formula for x obviously represents the present value of the stream of prospective yields calculated at a discount rate of r. Setting x equal to Ps and solving for r gives what Keynes called the marginal efficiency of capital, or equivalently what Fisher called the internal rate of return. Both Keynes and Fisher compared the value of r to the market rate of interest in deciding whether the investment would be undertaken. In my view, it is better to specify a value for r and then compare the resulting x to the value of Ps , as this represents a straightforward comparison of willingness-to-pay with the cost of the investment. Risk and uncertainty (in the sense of Knight and Keynes) can be seen as entering into the investment decision at four places in the formula for x, namely, in the estimation of Ri and Ci , the choice of a value for n, and in the choice of the discount rate r. If, for example, the investment decision is being made in an atmosphere of increasing uncertainty: 1. 2. 3. 4.
Estimates of Ri will be shaded downward; Estimates of Ci will be shaded upward; n – the “payback period” – will be decreased; r – the (subjective) rate of discount – will be increased.
The usual approach to dealing with risk and uncertainty is to treat it all as risk and to roll it into a “risk premium” to be added to the market rate of interest in choosing the value of r. This, in my view, does away with much of how uncertainty operates on real-world investment decisions – payback periods are shortened (not just because more remote yields are made small because of a higher discount factor),
5.2 From Production to Investment
55
and expectations concerning revenues and costs become less sanguine. The consequence, among other things, is a much weaker connection between decisions to invest and the market rate of interest than is usually posited.5 In interpreting the foregoing, it is to be emphasized that the investment being considered involves a particular configuration of capacity, whether already existing or purchased new from the capital-goods industry. It may represent the purchase of a 747 to carry passengers, lease of the same, or the purchase of a factory to make tennis rackets. The spot price, it must also be emphasized, is the price which places the existing stock of produced means of production into the hands of willing holders. Let us now look at the investment decision for an individual firm. For concreteness, assume that the firm is an electric utility and that the production capacity in question is generating capacity. The analysis is based upon assumptions as follows: 1. Generating stations are not only durable, but they require a considerable amount of time to build. Accordingly let h denote the number of periods that constitutes the firm’s capacity-planning horizon, by which is meant the period over which new capacity begun today can be brought on line in an orderly fashion. 2. The planning horizon h is to be viewed in a normal sense, in that capacity, in event of unanticipated factors, could be put into place more quickly, but at a higher cost. 3. The firm has an ongoing construction program that reflects past investment decisions. The program is reviewed each period to see whether the capacity needs for within-horizon periods as foreseen yesterday square with these needs as foreseen today. If not, projects can be accelerated or delayed as current circumstances dictate. 4. The motivation of the firm is assumed to be to produce electricity at each point (i.e., period) within the planning horizon at minimum cost, given the plant that is available. The details of the investment decision, for the end of the planning horizon, are depicted in Fig. 5.3. Two periods are represented in this figure, the current period, labeled 1, and the last period of the planning horizon, labeled h. The curve D1 D1 , represents the current-period demand function for generation capacity, while Dh Dh represents the demand h periods in the future, as anticipated from the current period. The spike at F1 , denotes current-period generating capacity, while Fh denotes the capacity that is currently planned for the end of the planning horizon. The curve abrepresents the short-run marginal cost curve (as defined earlier) of operating the capacity in F1 , and cd represents the same with respect to Fh (as expected from the current period). In deriving ab, it is assumed that existing capacity is ordered by
5
Cf. the loose relationship between investment and the rate of interest in the surveys of investment decisions in the UK in the late 1930s. See Hall and Hitch (1939).
56
5 Production and Investment
Fig. 5.3 From production to investment
Φ1 S Ph
Φh Dh
D1
d b
b
P1 a c
D1 x
Dh y
Output
operating efficiency (as measured by out-of-pocket operating expenses), so that the newest, most efficient plant is represented near the origin, while old inefficient plant is represented near F1 . This means that the curve ab will, in general, never fall, and (assuming a mix of plants of different vintages) must be higher at F1 than near the origin. The curve cd bears the same relationship to Fh as ab does to F1 , but with one important difference: the information is essentially current for the calculation of ab, while it is all based upon expectations for the calculation of cd. If the ongoing construction program (which reflects past investment decisions) unfolds as planned at the beginning of the current period, the demand Dh Dh that is foreseen for the end of the planning period would have an anticipated short-run marginal cost of Ph per unit of capacity. However, since demand h periods in the future can be served not only by capacity that (as of yesterday) is planned to be in place at that time in the future, but also by capacity the construction of which can be started today, how Dh is to be served is subject to some choice. We will now examine how this choice is determined. Let the horizontal line labeled b represent the average price per unit of capacity at which new capacity, started in the current period, can be brought on line at the end of the planning horizon. The value of b thus represents not only the operating expenses of production, but all capital costs as well. In Fig. 5.3, we see that for outputs beyond x, output can be produced most efficiently from new plant to be constructed from scratch. For, to the right of point x, b lies below the short-run marginal cost curve of utilizing the currently planned existing plant. From the figure, we see that the current period could involve plans to initiate up to y x new units of capacity to come on line h periods in the future. The point to be kept in mind in assessing this conclusion is that the total unit cost of new capacity has to compete with only the marginal operating cost of existing capacity. To the left of point x, the short-run marginal cost of operating Fh , is less than b, so that output demand less than x will be most efficiently served from (what at the beginning of the current period is planned to be) existing plant. To the right of x, b is less than points on cd, so that demand in excess of x would be most efficiently
5.2 From Production to Investment
57
served by new plant. This crossover of short-run marginal cost from being less to being greater than the total cost per unit of new capacity is what drives the decision to invest in new plant. We will now look into the investment decision at point x in more detail, beginning with the way that b is calculated. With some realism, we can imagine that as the firm’s capacity planners note that Dh cuts cd in a steeply rising portion of the curve, they go to a “catalog” (i.e., book of blueprints) of new-generating plant and begin to cost-out a variety of plant designs, under the assumption that new plant started from scratch today will be up-and-running in the final period of the planning horizon. For each plant design, the total cost of designing and constructing the plant, including all foreseeable getting-started expenses and all interest on loans that are taken out during the period of construction, is calculated. Let gðiÞ denote all of the construction and construction-related expenditures for a particular plant during period i in the construction horizon. The total (projected) cost of the plant calculated at the end of the construction period, will accordingly be G¼
h X
gðiÞð1 þ rÞi ;
(5.7)
i¼0
where r is an appropriate rate of interest. Let k denote the installed capacity of this plant. The value of b for this plant would then be calculated as b¼
G : k
(5.8)
A b will be calculated for each plant type and design. I now turn to how the earlier treatment of the investment decision fits into the present analysis. Earlier it was noted that a necessary condition for an investment to be undertaken is that the present value of the prospective stream of yields be greater than the cost of the investment. In the present context, this condition can be represented as n X Rj C j j¼1
ð1 þ rÞj
> G;
(5.9)
where Rj denotes the revenues expected from operating the plant in time h þ j, Cj denotes the (avoidable) cost of producing Rj , and r denotes an appropriate discount rate. It is to be noted that the point in time at which evaluations are made is the end of the planning horizon, which is h periods into the future. This reflects the assumption that it (normally) takes h periods for a new plant started today to be up-and-running. Capital expenditures for the plant accumulate at an interest rate r (see (5.7)). However, in contrast with capital expenditures, which accumulate interest to the
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5 Production and Investment
time that the new plant goes into service, the stream of prospective yields from the plant is discounted to that point in time. Note that capital costs are accumulated at a rate r, while prospective yields are discounted at a rate r. In general, r will be greater – possibly substantially greater – than r. The reason for this difference is that r represents the interest costs of building the new plant, while r represents the rate at which the firm discounts the future quasi-rents that the plant is expected to generate. The calculations just described will be made for each plant type and design that is in the firm’s present catalog of blueprints. In the end, the plant that will be selected for construction will be the one which yields the largest excess of x over G. A point to be emphasized is that, in evaluating the stream of prospective yields, the length of the payback horizon n need to bear no necessary relationship to the expected productive life of the plant. The only thing that can be said a priori is that n will never be greater than the expected productive life. What determines the time that plant is ultimately taken out of service is when its short-run marginal cost of operation is in the most steeply rising part of the short-run marginal cost curve, defined with respect to current capacity to produce. The payback horizon, on the other hand, represents the period over which the firm wants and expects to recover the capital that was initially invested in the plant. A plant can continue to generate quasi-rents long after the capital that was initially invested in it has been returned (via myros recovery charges against quasi-rents) to the pool of fluid capital. Such plant remains productive, and therefore has capital value (defined as the present value of its stream of prospective yields). We must take care, however, not to identify capital value defined in this sense with capital defined either as fixed (or sunk) capital or fluid capital. Finally, it should be noted that the analysis to this point implicitly assumes that the demand at time h which drives current investment decisions is permanent in the sense that it is expected to persist at least as long as the length of the payback horizon. To this point, I have focused on the investment decision related to the decision to initiate completely new investment projects. What about projects that are already in progress that are consequences of investment decisions made in periods in the recent past? As noted earlier, the firm is assumed, in the current period, to review each ongoing project, specifically to decide whether a project is to continue according to today’s inherited schedule, to be moved up, or to be delayed. Each review involves the same considerations as for the decision to initiate the construction of new plant that is to come on line at the end of the planning horizon. In discussing how construction-work-in-progress (or the ongoing construction program) is changed in response to changes in within planning-horizon expectations, let us begin with the case in which there is a change in demand for the current period in relation to what was expected in the immediately preceding period (i.e., “yesterday”), a change that is expected to be permanent. In analyzing this situation, it is to be noted, to begin with, that nothing can be done regarding the amount of capacity in this (the current) period, for today’s demand must be served from whatever capacity is inherited from yesterday. The first capacity that can be affected is the first period after the current one. If demand has increased, the capacity scheduled to be in place at the start of period 3 of the current planning
5.2 From Production to Investment Fig. 5.4 Changing an on-going construction program in response to an expected increase in demand
59 Φ1 S
D2 P2 P3 c a e
Φ2
Φ3
D2
d
f
b g
D2
D2 Output
horizon could be accelerated to be in place at the start of period 2. On the other hand, if demand has decreased, the capacity scheduled to be in place at the start of period 2 could be delayed until the start of period 3 (or later). Each of these actions will have costs as well as benefits. In particular, there will be two types of costs and benefits, namely, changes in quasi-rents and changes in capital costs. The circumstances at the start of period 2 are described in Fig. 5.4. The curve D2 D2 represents the (now) expected demand for period 2. The vertical line at F2 represents the capacity that was scheduled (according to yesterday’s plan) to be in service at the start of period 2, while F3 is the same for period 3. F1 represents the capacity that is available in the current period (i.e., period 1). The curve labeled ab represents the short-run marginal cost of operating F2 , and similarly for cd and ef with respect to, F1 and F3 . Finally, for reference, yesterday’s expected demand for period 2 is given by the curve D2 D2 , so that the figure describes an increase in demand. We now turn to the calculation of the appropriate benefits and costs that would arise from an alteration in the ongoing construction program. Since we are dealing with an increase in demand, the question is whether capacity scheduled to be in service at the start of period 3 that is, F3 – is shifted to the start of period 2. In the figure, we see that the short-run marginal cost of serving D2 from F2 is expected to be P2 , while expected short-run marginal cost of serving D2 from F3 (if it were moved up) would be P3 .6 The quasi-rents from using F2 will be given by the area aP2 b, while the quasi-rents from using F3 would be given by the area eP3 g. Let p2 denote the former and p3 the latter. Finally, let Dþ p denote the difference between p3 and p2 . In general – and this is important to note – Dþ p can be of either sign. Assuming that it is physically possible to do so, moving up the in-service date of F3 will clearly entail capital expenditures that are in addition to those that are part of the inherited construction program. Denote this increase in capital expenditures that would have to be incurred in the current period by Dþ G. If the difference between Dþ p and Dþ G is positive, the firm will have incentive to 6
Since we are dealing with an increase in demand, we can (at least for the moment) ignore F1 .
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move up the in-service date of F3 , but not if the difference between Dþ p and Dþ G is negative. Suppose that the difference between Dþ p and Dþ G is not positive, so that the inservice date of F3 is not moved up to the start of period 2. The question that must next be asked is whether the in-service date of F4 will be moved up to the start of period 3. A figure similar to the one above can be constructed, but with reference to period 3. The demand curve D3 D3 will replace D2 D2 , and the reference F’s will be F2 , F3 , and F4 . The quasi-rents for serving D3 from first F3 and then F4 will be calculated as before, and the differences between the two compared with the additional capital costs that would be incurred (including interest expense) in moving the in-service date for F4 to the start of period 3. If the difference between Dþ p and Dþ G is again negative, the analysis proceeds to period 4 and calculation of the benefits and costs of moving up the in-service date of F5 for serving D4 , and so on for the remaining periods within the planning horizon. Question: Does a move-up in the in-service date of F2 (say) imply that the inservice date of F3 ; . . . ; Fh will also be moved up? This will not necessarily be the case. In Fig. 5.5, the demand curve D3 D3 represents revised expected demand in period 3. The vertical line at F2 denotes the now planned capacity for period 2, which was the planned in-service capacity for the start of period 3 (according to yesterday’s construction schedule), but now planned to be moved to the start of period 2. Finally, F4 represents the in-service capacity for the start of period 4 according to yesterday’s construction schedule. F3 has been moved up, will F4 as well? Whether this will be the case depends (as before) upon whether the difference between the change in quasi-rents and the capital costs (including interest) associated with the move-up is positive. The quasi-rents corresponding to F2 and F4 will be given by aP2 e and cP4 f . As before, the difference between these two quasi-rents can be of either sign. The capital cost associated with the move-up will be the difference in capital costs (including interest) between what, beginning in the current period, the construction cost would be if F4 were put into service at the start of period 3, and what the construction cost would be if F4 were put into service (according to the inherited plan) at the start of period 4. A similar analysis must be undertaken for each
S
D3
Φ4
F2
b P2
Fig. 5.5 Changing an on-going construction program in response to an expected increase in demand, continuation
P4 a c
d
e f D3
Output
5.2 From Production to Investment Fig. 5.6 Changing an on-going construction programs in response to an expected permanent decrease in demand
61 D2 S
Φ1
Φ2
D2 d
P2 P1 P2 a c
b e
f
D2 D2 Output
succeeding period in the planning horizon. The analysis for the last period in the horizon is the one depicted in Fig. 5.3, which is the one that began the discussion. Let me now turn to a decrease in demand in the current period that is expected to be permanent. For a decrease in demand, the concern will be with delays in the ongoing construction program, rather than move-ups. Beginning with period 2 of the current planning horizon, the first question to be asked is whether the (now) expected demand for period 2 should be served by the capacity of the current period or whether it should be served by the capacity that was planned (per the inherited plan) to be in-service at the start of period 2 – i.e., is D2 to be served by F1 , or F2 ? The situation is described in Fig. 5.6. D2D2 represents the demand in period 2 expected in the inherited plan, while D2D2 represents the demand in period 2 that is currently expected. The quasi-rents from using F2 to serve D2 are represented by cP2 f , while the quasi-rents from using F1 , are given by aP1 e. To delay placing the capacity represented by F2 into service from the start of period 2 to the start of period 3 will result in a capital saving. The condition for F2 being delayed is for the sum of the capital saving (including interest) and the difference in quasi-rents to be positive. If F2 is delayed, the next step is to check whether the delay carries into subsequent periods, that is, whether F3 ; . . . ; Fn should be delayed as well. Each period should be analyzed sequentially, using as comparison Fs, the F that would be inherited by that period in relation to the F of one delay removed. To illustrate, suppose that the capacity represented by F2 is delayed through period 3. Then, the comparison for period 4 will be F2 with F3 , not F2 with F4 . And so on and so forth. If, rather than in the current period the permanent change in demand is expected to occur in the jth period of the planning horizon, the analysis as just described, for both an increase and a decrease, is to be applied beginning with the period in which the change in demand is expected to occur.
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5.3
5 Production and Investment
Roles of the Money and Natural Rates of Interest
The natural rate of interest, it will be recalled, represents the price that equilibrates demand and supply in the market for fluid capital. On the demand side, an increase in current maximum prospective outputs on the part of individual firms could cause an increase in the streams of future prospective outputs, which in turn could cause an increase in the streams of future prospective quasi-rents. Since it is the latter which drive investment decisions, the result could be an increase in investment and therefore an increase in the natural rate of interest. However, a different scenario can also be envisioned which operates on the cost side, namely, where (say) a prospective decrease in the real wage rate leads to a lengthening of the period of production – i.e., to a less mechanized structure of the production process – and hence to a lessened demand for investment.7 In this case, the pressure on the natural rate of interest would be downward. Consequently, it follows that the overall impact of a prospective decrease in the real wage rate on the natural rate of interest is ambiguous. As has been discussed, however, the money rate of interest can intercede between the natural rate of interest and both saving and investment. As we have seen, new investment is financed through the intermediary of money, that is, firms wishing to invest must first acquire an appropriate stock of money. Assuming that the money in question is obtained through bank loans, the cost of this stock of money is the money rate of interest. In the short run, as we have seen, the money rate of interest bears no necessary relationship to the natural rate. A high money rate of interest can clearly forestall investment, even though the natural rate might be sufficiently low to encourage it.8
5.4
Financing of Investment: An Illustration
Let me now turn to an example that shows how investment in new capacity might be financed. Assume that the time required for the new capacity to go on line is 6 months. This means that finance will have to be arranged not only for the plant, equipment, and materials to be purchased, but also for the wage payments that will be required in putting the new capacity into place. The sum total of this finance represents the capital, drawn from the pool of fluid capital that will be invested in the project. Suppose that the investment will total US $10 million, of which US $8 million is for plant and equipment and US $2 million for labor. Suppose, further, that US $6 million is financed internally and US $4 million externally, US $2 million through the sale of new equity and US $2 million through the sale of 10-year bonds. Of the 7 8
The circumstances under which this contingency can arise are described in Appendix B. Cf. Keynes’s discussion of the “finance” motive for holding money [Keynes (1937b)].
5.4 Financing of Investment: An Illustration
63
US $6 million financed internally, assume that US $2 million is drawn from the firm’s demand deposits and that US $4 million is raised through the sale of government bonds from the firm’s portfolio. Of the US $4 million financed externally, assume that the bonds are purchased by a pension fund, while the US $2 million of equity is purchased by an individual who paid for the shares through the sale of US $2 million of equities in another company. Without further specific assumptions, there is no way of saying how much of the US $10 million is financed out of current saving, how much out of current myros recovery charges, or how much is simply drawn out of the pool of fluid capital. The only thing that can really be said is that US $10 million of purchasing power is required by the firm for pursuing the investment, US $2 million of the firm’s own cash and US $8 million from outside the firm, with the latter consisting of US $4 million from the firm’s sale of government bonds from its own portfolio, US $2 million from the sale of equity, and US $2 million from the sale of its own bonds. The firm gives up interest on the government bonds, will have to pay interest on its own bonds, and will expect to pay dividends on the equity. At one extreme, all of the US $10 million investment could be drawn from current saving. This would be the case (say) if the US $2 million from the firm’s own cash came out of current retained earnings, if the US $4 million of government bonds were purchased by an insurance company out of current premium payments, if the US $2 million of bonds sold to the pension fund were purchased out of inflows into the fund out of current income, and if the individual that purchased the shares of the second company did so out of current income. The other extreme would be all US $10 million that was raised represented restructuring of asset portfolios, so that the US $10 million investment would be financed from the already existing pool of fluid capital.9 The firm undertakes the US $10 million investment because fluid capital invested in new produced means of production is expected to be productive – productive in the sense that, over some specific horizon, use of the produced means of production is expected to generate discounted quasi-rents that are in excess of the US $10 million cost of the investment. The US $10 million of fluid capital invested will be recovered through myros recovery charges against the quasi-rents, while the opportunity cost of the capital that remains sunk (i.e., embodied) in the produced means of production is accounted for in the rate that was used in discounting the expected quasi-rents.
9
This case also illustrates how investment can take place in the absence of current saving.
Chapter 6
General Price Level and Inflation
I turn now to what I have always thought are among the most difficult topics in economics, the concepts of the general price level and inflation. Inflation is, and always has been, easy to define as a rise in the general price level. But, what is meant by the general price level and what are its determinants? Of the two questions, the first is logically prior, for one has to know what the general price level is before changes in it can be discussed. The real task, accordingly, is to come up with a definition of the general price level that is fruitful for further analysis.
6.1
Defining the General Price Level
The usual response to the question of what is the general price level is that it is an index number, specifically, a price index. This seems unassailable. Irving Fisher spent many years thinking and writing about how such an index should be defined, and the same was true for Keynes. An important question, however, is whether any index that is devised is simply an artificial construction devoid of meaning beyond the context within which it is defined, or whether an index can be defined that is meaningful in its own right. Let us begin with the classic equation of exchange, MV ¼ PT, where the terms have their usual meanings. My first question is which of these terms can meaningfully be measured.1 That M, the stock of money, can be measured there seems little question. For once a definition of money is settled upon, measurement (in principle) is simply a matter of counting. Also, there seems little question but that the righthand side of the equation of exchange is in principle measurable, for once the transactions (together with the time period) that are to be measured are specified, the matter is once again one of counting and adding-up. This, however, is with 1
That all of the terms in fact are measured in some form or another is not the issue; the question is which of them can be meaningfully measured. L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_6, # Springer ScienceþBusiness Media, LLC 2010
65
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6 General Price Level and Inflation
P reference to the monetary pi Ti , rather P value of transactions as represented by P represents some price level. than by PT, where T ¼ Ti and P Since M and PT (viewed as pi Ti ) are in principle measurable, velocity, V, can then be measured as X V¼ pi Ti =M (6.1) Note that this makes the equation of exchange an identity. The question P now is whether it is meaningful to replace the volume of monetary transactions pi Ti by PT, where P represents an index of the general price level. This question will be returned to in a moment. The preceding paragraph refers to the totality of all transactions (obviously with reference to some specified period of time) in an economy. There is also a standard quantity equation that refers to income (or GDP). In this quantity equation, the right-hand side represents the monetary value of final transactions. The stock of money is still defined as in the total transactions equation, but now velocity has to refer to income (or GDP) transactions. The conventional way of writing the income equation of exchange is as X (6.2) MV ¼ pi Qi where pi and Qi represent the prices and quantity of the ith component of final output. Even more conventionally, this is written as MV ¼ PQ
(6.3)
where P denotes an index of the general price level and Q denotes real output. A common practice is to represent P by the P GDP deflator and Q by real GDP. Ex post, there is no question but what pi Qi can be represented by PQ, where P and Q are as just defined. The key question, however, is whether the general price level in an ex ante sense – or better still, in a sense that stands apart from its individual constituent prices – is a meaningful concept. Can we, for example, imagine the general price level as representing, in some abstract sense, the mean level of a series of interconnected “lakes” that represent the markets in an economy in which individual prices are formed? Or is it better to think of the general price level as the mean level of a single big “lake” that represents all of the markets in an economy rolled into one? In the Purchasing Power of Money, Fisher likens the Equation of Exchange to a physical balance, with MV on the left side and PT on the right. In Fig. 6.1, the stock of money (M) and the amounts of goods (Q1, Q2, Q3) are interpreted as weights, while velocity (V) and prices (P1, P2, P3) are interpreted as distances that M, Q1, Q2, and Q3 are from the fulcrum of the Pbalance. The Equation of Exchange is depicted in this figure in the form MV ¼ pi Qi . In Fig. 6.2, the Equation of Exchange is depicted in its usual form as MV ¼ PQ. M and V are as before, but now P represents an average P price that applies to all of the quantities hanging from the same point ðQ ¼ Qi Þ.
6.1 Defining the General Price Level
67
Fig. 6.1 Irving Fisher’s Equation of Exchange: version 1
P3 V
P1
M
V
Q1
P2
Q2
Q3
P
M Q1 Q2 Q3
Fig. 6.2 Irving Fisher’s Equation of Exchange: version 2
Fisher conducts all of his monetary analysis in terms of the Equation of Exchange. He is a quintessential quantity theorist: V and T are taken as constant (or exogenous), so that P and M must necessarily vary proportionately. For Fisher, however, the causation is clearly from M to P, that is, the general price level is determined by the stock of money.2 A point that Fisher makes repeatedly is that prices (specifically, goods prices) are determined independently of the general price level, or alternatively the general price level is determined independently of prices: 2 The Quantity Theorists – and Fisher, in particular – are dogmatic in connecting inflation to changes in the stock of money. As we have seen, excess aggregate demand is at root caused by excess monetization, so that there is truth in the dogma. In my view, however, it is better to see the problem in process terms, as the creation of a tide of purchasing power that floods onto the goods side of the pool of fluid capital and drives up market-clearing prices. A major problem with quantity theorists, with the exception of Wicksell, is that they neither specify a reason why excess monetization occurs, nor do they spell out a mechanism whereby the excess purchasing power that is created eventually leads to inflation. The standard litany of quantity theorists is: “Suppose the quantity of money is doubled.” Clearly, the most fanciful deus ex machina for bringing this about is Milton Friedman’s helicopter that flies about spreading money to one and all.
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6 General Price Level and Inflation We have seen that the price level is not determined by individual prices, but that, on the contrary, any individual price presupposes a price level. We have seen that the complete and only explanation of a price level is to be sought in factors of the equation of exchange and whatever antecedent causes affect this factor. The terms “demand” and “supply,” used in reference to particular prices, have no significance whatever in explaining a rise or fall of price level. In considering the influence affecting individual prices we say that an increase in supply lowers prices, but an increase in demand raises them. But in considering the influence affecting price levels we enter upon an entirely different set of concepts, and must not confuse the proposition that an increase in the trade (the Q’s) tends to lower the price level, with the proposition that an increase in supply tends to lower an individual price. Trade (the Q’s) is not supply – in fact it is no more to be associated with supply than with demand. The Q’s are the quantities finally sold by those who supply, and bought by those who demand. Fisher (1911), p. 180.
Much of this paragraph strikes me as mystical. Nowhere in Fisher’s writings have I been able to find a place where he discusses the determinants of the volume of trade, except to note that this is determined by technology and tastes. In view of the time period that Fisher formulated his ideas and he was writing – The Theory of Interest, his last great book, was published in 1930 – this is hardly surprising. Fisher almost certainly accepted the view of the time that real activity was determined independently of monetary matters and that equilibrium for real output was always at full employment. At one point in The Purchasing Power, Fisher describes the difference between individual prices and the price level in terms of a wave/water-level analogy. He notes that the shape of individual waves in a body of water are independent of the water level, but that given the level, a high wave (or waves) must necessarily be offset by a low wave (or waves). The water level in this analogy represents the price level, while the height of waves represents individual prices. The tops of waves, measured from the mean water level, represent prices above the mean level of prices (i.e., the general price level), while troughs, again measured from the mean water level, represent prices below the mean level of prices. Fisher’s wave/water-level analogy provides a useful point of departure, but I think it can be made even more meaningful by viewing the water in terms of its total volume rather than its mean level and then taking into account the capacity of the reservoir in which it is held. As has been emphasized throughout these pages, the stock of money, apart from fiat money, arises through the monetization of the pool of fluid capital. Money is created through the granting of credit (i.e., loans) by banks primarily for the purpose of financing current production. The stock of money, accordingly, is also a pool that is constantly being extinguished and replenished through the paying off of existing loans and the granting of new ones. The size of the pool at any point in time is therefore primarily determined by the interactions of expectations of firms and banks as to how much ought to be produced out of existing capacity. As production proceeds, income is generated, which represents claims on current output. However, since income is paid in money, these claims at the point that income is paid are represented by money. Income can accordingly be seen as a pool of monetized purchasing power that is juxtaposed against current production (both represented as flows). If all production were destined for current consumption, then the income
6.1 Defining the General Price Level
69
generated would just be equal (in current prices) to the value of current production. The pool of purchasing power represented by current income could therefore not put upward pressure on the monetary value of current production – i.e., there could be no upward pressure in this situation on the general price level.3 However, there are two other sources of demand for current production that need to be considered, investment and consumption that in the aggregate is greater than current income. Since the pool of fluid capital represents the maximum that is available in a closed system to consume or invest, it is simply a matter of arithmetic that the general price level will tend to rise whenever the aggregate of planned consumption and investment purchases, at current prices, is greater than the pool of fluid capital (also evaluated at current prices). Let us suppose for the moment that this situation actually holds, i.e., that aggregate planned purchases is greater than “aggregate supply” (as represented by the stock of fluid capital).4 How will upward pressure on the general price level be manifested?5 Fisher would appear to say that this somehow happens directly, without the intermediary of individual prices. But this does not make sense. While the excess purchasing power that causes the inflation can arise independently of individual prices, individual prices have to figure in the actual inflation. A preponderance of transactions simply has to occur at higher prices. The way that this will come about is that the excess purchasing power will drive willingnessesto-pay (i.e., demand) functions to the right, thereby increasing market-clearing prices. If the excess purchasing power funnels into all markets, all prices will increase. If the excess purchasing power funnels into just a few markets, prices in these markets will increase, but prices in the other markets will not go down because there is no diminution in the purchasing power going into them. Indeed, prices in these other markets may actually increase as well because of substitution. The general price level will go up in either case. The foregoing describes the classical demand-pull type of inflation of “too much money chasing too few goods.”6 This situation can occur in two ways. The first is through the creation of too much credit by the banking system, while the second is through too much government spending financed by borrowing from the central bank. If the banking system were to make loans only for the purpose of financing
3 I am abstracting, for the moment, from the fact (discussed in Chap. 4) that the expectations which drive the current supply of goods and the expectations which drive the current flow of income are in general separated by one-half of an average production period. 4 I put aggregate supply in quotation marks in this sentence in order to distinguish aggregate supply as it is being conceived here from the aggregate supply that was defined in Chap. 3. Aggregate supply defined there refers to the flow of output that is currently emerging from production, whereas the aggregate supply defined here refers to the entire stock of goods embodied in the pool of fluid capital. The latter differs from the former by the addition of held-over inventories of finished goods from past production. 5 I put to the side for now the question of how an excess of purchasing power could come to exist in the first place. 6 The situation is actually better described as too much purchasing power chasing too few goods.
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current production, then in general the only way that banks could create too much credit would be because expectations are too rosy as a whole. On the other hand, government purchases financed by borrowing can easily lead to too much aggregate demand. This is clearly most likely to arise when the bonds that finance the expenditure are sold to the central bank, for this is equivalent to running the printing press. It is less likely in the case of bonds sold to the public, for this will usually involve a transfer of existing purchasing power from the public to the government. As has been noted, income in general is generated in the form of monetized purchasing power. However, we have also noted that, for any given flow of income, the money with which the income is paid has been created prior to its payment. This means, among other things, that the current price level, in an important sense, is already embodied in the flow of current income. Spending out of current income, accordingly, cannot be a contributing source of excess aggregate demand. The source of excess spending has to be in the monetization that takes place prior to the payment of income. A clear implication of the foregoing is that inflation arises not from the income generated by current production, but from the purchasing power that has been created to finance current production. For this is the pool of purchasing power which pours onto the existing stock of goods and services and either ratifies or changes current prices, and therefore affects the current price level. If this pool of purchasing power (measured as a flow) is greater than the stock of fluid capital valued at current prices, then at least some market-clearing prices must increase, thereby leading to an increase in the current price level (and hence inflation).7 The preceding implicitly assumes competitive markets in that any excess purchasing power leads to an increase in the general price level. By the same token, any shortfall in purchasing power will lead to a decrease in (at least some) prices, and therefore to deflation. With competitively determined prices, it is unambiguously clear that inflation (and deflation) is a monetary phenomenon, in that movements in the general price level are tied to “abnormal” monetization of the stock of fluid capital. I want to turn now to the case in which prices (at least a number of “key” prices) are not determined competitively, but are administered in some form or another. The question is whether inflation can occur in the absence of aggregate spending that is in excess of current aggregate supply. As labor accounts for more than 60% of factor payments, let us consider a situation in which labor is hired under a contract that specifies a wage increase that is in excess of productivity gains. Suppose, too, that the firms involved possess some market power in their
7 As discussed by von Mises in The Theory of Money and Credit – and in great detail by Schumpeter in The Theory of Economic Development – demand-pull inflation necessarily results in “forced savings.” This is because the “extra” purchasing power allows goods to be bid away (through higher prices) from those with lower willingnesses-to-pay. Indeed, Schumpeter saw this process as the essence of development, because it is the (new) purchasing power in the hands of entrepreneurs which allows resources to be transferred from old uses into new uses. Forced saving will be discussed below.
6.1 Defining the General Price Level
71
Fig. 6.3 Short-run demand and cost conditions for a typical firm
K S
D b
p
a D 0
q
Output
product markets in the sense that they face demand functions that slope downward. Suppose, also, that there is unemployment. Figure 6.3 describes the short-run demand and cost conditions for a typical firm. The firm’s short-run capacity to produce is given by the vertical line at K, the shortrun marginal cost of operating this capacity is given by the curve ab, and the demand that it expects to face is given by DD. From earlier discussion, we know that the firm would never choose to produce more than q (since an output greater than q could only be sold at a price that is less than short-run marginal cost), but it may choose to produce an amount less than q which could be sold at a price greater than p. The actual amount the firm chooses to produce will depend upon how much market power the firm feels it has. The details of this need not concern us. Since wages are the major component of short-run cost and since the money wage is assumed to be increasing faster than the rate-of-growth of productivity, the firm knows that its short-run marginal cost curve will be higher next period than in this period. If the firm thinks that its experience is typical of costs and incomes in general, it will also expect next period’s demand function to lie to the right of where it is this period. Real demand might be expected to be the same, but money demand would be expected to be higher. In these circumstances, the firm will need a larger loan to finance production for next period than was needed for this period. The firm’s bankers will almost certainly go along with the request. The larger pool of purchasing power that is created will allow the higher prices that are expected to actually materialize. The foregoing describes an inflation that is a cost-push type. The stock of money in this situation is seen to increase in anticipation of the inflation. Actual inflation is, of course, caused by the larger pool of purchasing power pouring onto the same amount of goods (for the firms and markets in question), but the larger pool was created in the first place by the anticipation of higher prices. An increased money stock in this situation is, in effect, a consequence of inflation rather than the cause. The appropriate framework for analyzing the determination of the general price level, it seems to me, is to balance the existing pool of fluid capital, valued at current prices, against the pool of purchasing power that has been created in anticipation of current production, which is also valued in current prices.
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If the two pools are equal (in volume), there should be no change in the general price level, though there might be changes in individual prices. If the pool of purchasing power is larger than the pool of fluid capital, we should expect prices in general to increase, leading to an increase in the general price level. On the other, if the pool of purchasing power is smaller than the pool of fluid capital, we should expect the general price level to decrease. In non-competitive circumstances, on the other hand, different results could obtain. If the pool of current purchasing power is larger than the pool of fluid capital, then we should once again expect, for reasons already noted, the general price level to increase. However, if the pool of purchasing power is smaller than the pool of fluid capital, the general price level may not decrease because of failures of administered prices to be reduced. In short, excess aggregate demand will lead to inflation, but a shortfall in aggregate demand need not lead to deflation. In defining aggregate supply as the pool of fluid capital valued in current prices, an index for the general price level is thereby implicitly defined. The weights in the index correspond to the physical quantities that comprise the goods side of the pool of fluid capital. Since the pool of fluid capital can in principle be valued at each point in time, the index in question is accordingly well-defined in terms of a current quantity-weighted price index. Changes in the general price level can then be defined in terms of changes in this index.8 In Fig. 6.4, let the stock of fluid capital valued at current prices be represented by the vertical line at K*. Define K* on the vertical axis as well. Let K, defined on the vertical axis, represent the pool of purchasing power that is confronting the goods embodied in the pool of fluid capital. K in this context, can be viewed as aggregate demand and K* can be viewed as aggregate supply. Since K>K in the figure, aggregate demand is greater than aggregate supply, the general price level must therefore rise in order for constituent markets to clear. The increase in the general price level will accordingly be given by the ratio of K to K*.
6.2
Problems Arising from Excessive Monetization of Assets
As has been noted earlier, there is a strong, though often times implicit, tendency in the literature to treat the stock of money as something apart from the level of economic activity. A point I have emphasized in these pages is that this is not the 8 Since some production decisions take place at each point in time, the two pools defining aggregate demand and aggregate supply change continuously. Conceptually, therefore, changes in the general price level are also best viewed as occurring continuously, in response to the ebb and flow of the pool of purchasing power against the stock of goods embodied in the pool of fluid capital. However, as data are necessarily collected over intervals of time, rather than continuously, defining a price index that changes continuously is obviously a practical impossibility. Of existing conventional aggregate price indices, the one which comes closest to the continuously chained index which emerges from this discussion is the implicit deflator for GDP. This is because the implicit GDP deflator is, in principle, a current quantity-weighted index.
6.2 Problems Arising from Excessive Monetization of Assets Fig. 6.4 Determining changes in the general price level
73
Aggregate Purchasing Power K K*
0
K*
Stock of Fluid Capital Valued at Current Prices
case. The nominal stock of money can obviously be any quantity, but the real stock is always constrained by the pool of fluid capital, for it is the latter that is available to be monetized. Nevertheless, it might be thought that the stock of produced means of production is also available to be monetized, as assets are frequently mortgaged or provided as collateral in order to obtain loans that are used to purchase other assets or to finance current consumption. In a world of perfect information and perfect crystal balls, there would never be a need to collateralize loans. Production loans would be self-liquidating, while consumption loans would be retired out of future income. If bankers were “prudent” in such a world, inflation would never be a problem because the amount of money created would never exceed the value in current prices of the pool of fluid capital. In the real world of uncertainty and imperfect information, however, most loans are collateralized. If all goes well, loans will be repaid out of quasi-rents or revenues, and those that are not (because expectations are not fulfilled) will be covered through the forfeiture of collateral. Once again, “prudence” essentially guarantees that money creation will be bounded by the pool of fluid capital. While collateralization of loans is clearly reflective of good banking practice, there is nevertheless an associated danger, namely, that vigilance will be relaxed in assessing the expectations that drive the loan demands to begin with. The worst danger is the situation of excessive collateralization of loans for purchasing existing assets, rather than for financing current production or investment in newly produced means of production. Excessive monetization of assets is virtually certain to lead to problems because, as asset prices begin to rise – as they must in the short run because of a fixed supply – the ground is laid for new loans to be made using the newly emergent capital gains as collateral. A speculative bubble in asset prices is accordingly created.9
9 So long as the money that is created by an excessive collateralization of assets remains in the asset markets, goods prices will not be affected. But there is the obvious danger that this will not remain the case, so that there could be inflation in the goods market as well.
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The question now becomes: what happens when the speculative bubble in asset prices bursts, as it eventually must? Clearly, there will be a deflation in asset prices, but will there be a spillover into the goods market as well? Whether or not this is the case will depend primarily upon what happens to expectations. If expectations are adversely affected, then investment will almost certainly be depressed, and consumption may become depressed as well, as a consequence of an increased desire to save. The result will almost certainly be unemployment and possibly depressed goods prices – in short, a situation not unlike what occurred in the USA during the late 1980s and early 1990s. One of the implications of the foregoing is a need, when speaking about inflation, to distinguish between inflation in asset prices and inflation in goods prices. Ordinarily, when economists speak of inflation, it is with reference to the goods market. When inflation is viewed just in terms of changes in the general price level for finished goods, it would seem (in view of the experience since WWII) that deflation is a thing of the past. But this is too narrow a view of how money and monetization impinge upon the economy. For it is clear that, while downward flexibility may be (currently) absent from goods prices, this is not the case with respect to asset prices. For speculative bubbles in asset prices that are induced by excessive monetization of assets (both real assets and financial) must necessarily burst, leading to a fall in asset prices to a level consistent with the current value of the pool of fluid capital.10 One of the consequences of an asset price deflation following the bursting of a speculative bubble is a forced transfer of assets from debtors to creditors. Not only do debtors face disaster, but many creditors as well, because many loans collateralized by the capital gains that accompanied the run-up in asset prices will themselves have a failure of collateral (i.e., a liquidation value that is less than the face value of the loan). The speculative bubbles in Midwestern agricultural land during the late 1970s, commercial office properties in the late 1980s, and residential housing in 2002–2007 are clear cases in point. One of the conclusions of all this is that, in the aggregate, monetization of produced means of production involves an illusion. Although monetization of nonmonetary assets is possible for an individual, this is not the case in the aggregate, for once again a fallacy of composition is involved. Loans secured against the value of produced means of production are, in effect, secured against both current and future income, not just current income as is the case with loans secured against the pool of fluid capital. Money as a means of payment that arises out of monetization of produced means of production is, therefore, potentially extremely inflationary if
10
Another way of stating this is that, in equilibrium, asset prices are tied to goods prices, and that causation in fact runs from goods prices to asset prices, rather than vice versa. The deflation of asset prices that occurred in Japan in the early 1990s is a case in point, as is also the bursting of housing bubbles in the U.S and other countries in 2006–07.
6.3 The General Price Level and the Natural Rate of Interest
75
it flows onto the goods side of the pool of fluid capital. This is because (to emphasize again) the real value of the pool of current purchasing power is necessarily constrained (in a closed system) by the pool of fluid capital valued in current prices. If the pool of fluid capital is fully monetized, then any monetization of produced means of production that adds to the stock of money as a means of payment (as opposed to the stock of money as an asset) is necessarily inflationary.
6.3
The General Price Level and the Natural Rate of Interest
The natural rate of interest has been defined in terms of the market-clearing price in the market for fluid capital. In the discussion of inflation and the general price level, we have defined changes in the general price level in terms of aggregate demand and aggregate supply, both of which are also associated with the pool of fluid capital. Does this mean that the natural rate of interest is simply another way of looking at the general price level, and vice versa? The natural interest rate and general price level are closely related, but they are different prices in different markets. As has been emphasized, the pool of fluid capital has two sides. In a sense, it is like a coin. One side, the obverse (or “heads”), represents the remnants of past saving that are not tied up in produced means of production. It is what is available to finance new investment, current production, and current consumption in excess of current income. This is the “capital” side of the pool of fluid capital. The natural rate of interest is the price which clears demand and supply in this “capital” market. The second side of the pool of fluid capital, the reverse (or “tails”), represents the inventories of unconsumed consumables, intermediate goods, and investment goods. This is the stock that is consumed or used as input into current production – food that is consumed by labor, fuel to power machines, raw materials, intermediate goods, etc. In a monetary economy, this stock of goods is purchased (or absorbed) by the pool of purchasing power that is created through monetization of the “capital” side of the pool of fluid capital. In a monetary economy, goods are transferred through money prices. These prices are established through the interaction of myriad markets, with the general (or absolute) level of prices being determined by the volume of general purchasing power that flows from the “capital” side of the pool of fluid capital onto the goods side. The general price level, as we have seen, can be defined only implicitly, and really has meaning only in terms of changes. The general price level can be viewed as changing when the volume of purchasing power emanating from the “capital” side of the pool of fluid capital is different from the value (at current prices) of the stock of unconsumed consumables and investment goods. The general price level accordingly represents the “price” (interpreted as an index) which adjusts aggregate demand to aggregate supply on the goods side of the pool of fluid capital. The implication of all this is that, since the two sides of the pool of fluid capital obviously have to be in equilibrium with one another when the economy
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is in equilibrium, equilibrium on the “capital” side implies equilibrium on the goods side. Three equivalent conditions for macroeconomic equilibrium accordingly emerge: 1. Equilibrium of supply and demand in the market for fluid capital. 2. Equilibrium of aggregate demand and aggregate supply. 3. A stable general price level.
6.4
Equilibrium in the Natural and Money Rates of Interest
Let us now turn our attention to the question of how the money rate of interest is related to the natural rate of interest and the general price level and whether, in equilibrium, the money and natural rates of interest are equal. The money rate of interest, to recall, represents the price at which the pool of fluid capital is monetized, while the natural rate of interest represents the price that adjusts the demand for claims on the pool of fluid capital with the supply of claims. These are different prices in different markets, and it is clear that, in real time, there is no simple mechanical connection between them. On the other hand, it is equally clear that what goes on in one of the markets influences what goes on in the other. We begin with demands for goods from the pool of fluid capital.11 These demands initially have to be pursued with money, so that in general the first price that demanders of goods see is the price of acquiring claims to money. The needed money can be obtained either through bank loans or by inducing owners of existing money to give up their holdings. The price charged by banks is clearly a money rate of interest, for loans represent the creation of new money. However, the price paid to individuals is not a money rate of interest, but a natural rate of interest, because the transactions involved are the transfer of existing claims on the pool of fluid capital (which happen to be in the form of money), rather than the creation of new money. Since the liquidity premium on money sets the lower bound to the price at which holders of money will relinquish their claims, this means that the natural rate of interest must ultimately adjust to liquidity preference. In a fractional reserve banking system, however, banks can obtain reserves from the central bank as well as from holders of money. This means, accordingly, that the money rate of interest is constrained by liquidity preference only when the cheapest way for banks to obtain reserves is by inducing holders of money to transfer some of their holdings to the banks. In this situation, there is a direct link between the money and natural rates of interest. This is because the money rate of interest is being determined by the liquidity premium on money, which is itself a natural rate. The 11
The demands in question are those which arise from the funding of current production, investment in newly produced means of production, and consumption in excess of current income. Current consumption demands are not included because these demands are funded out of current income, which is paid in money.
6.4 Equilibrium in the Natural and Money Rates of Interest
77
link is broken, however, when banks are able to obtain reserves from the central bank at a price which is less than the liquidity premium on money. And when this occurs, the stage is set for a “cumulative process” of inflation to come into existence a la Wicksell. The problem is that a money rate of interest that is less than the natural rate of interest can fuel the creation of an aggregate demand that is greater than aggregate supply. The result, in line with the discussion earlier in this chapter, will be an increase in the general price level. Once begun, the inflation can feed upon itself, as a new pool of purchasing power is created in anticipation of higher prices, the anticipated inflation is realized, and so on. From this, it is clear that an economy cannot be in equilibrium with a money rate of interest that is less than the liquidity premium on money. Since in equilibrium the natural rate of interest and the liquidity premium must be equal,12 it follows that the money rate of interest in equilibrium can never be less than the natural rate. The only question, then, is wheth er in equilibrium the money rate can ever be greater than the natural rate. If the money rate of interest is greater than the natural rate, this means that demanders of current purchasing power can obtain the money needed directly from the “capital” market cheaper than it can be obtained from banks. This will obviously put upward pressure on the natural rate of interest, driving it toward the money rate. The conclusion from all this, consequently, is that money and natural rates of interest will be equal in equilibrium.13 Although it has not previously been described in these terms, the results of this chapter can be interpreted as representing the equilibrium, or steady-state implications, of the conservation laws that are imposed on a closed economy by the pool of fluid capital. We have seen how the pool of fluid capital provides for natural (and consistent) definitions of aggregate demand and aggregate supply, how aggregate supply in turn provides for a natural (although implicit) definition of the general price level, and how inflation or deflation then results from adjustment of aggregate demand to aggregate supply. An equilibrium price level is then defined in terms of aggregate demand being in equilibrium with aggregate supply. From here, we go on to show that associated with an equilibrium price level is an equilibrium natural rate of interest equal to an equilibrium money rate of interest. All of these are, in
12
This follows from portfolio adjustment in which yields on different assets, including money, are equalized. 13 This might accordingly seem to imply a horizontal equilibrium yield curve, but this is not necessarily the case. The conventional view at present (at least in elementary money and banking textbooks) seems to be that long-term interest rates are determined as geometric means of expected short-term rates. [cf., for example, Burton and Lombra (2000).] The normally positive slope of the yield curve is then seen as a consequence of the greater uncertainty which attaches to expectations the further they lie in the future. Another factor to be taken into account is the option loss associated with a long-term security as opposed to a short-term one. Since the future is unknown, an “investor” unexpectedly needing money might have to sell a long-term security at a loss before its maturity. To compensate for this possibility, long-term rates will need to be higher than shortterm rates. An additional liquidity premium will accordingly attach to short-term rates. For an analysis of this option effect, see Hlusek (1999).
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essence, equivalent implications of an equilibrium in the market for fluid capital in which inflows into the pool of fluid capital are in balance with outflows. What is meant by equilibrium in this context is a steady-state equilibrium in which the expectations driving the levels of current production, consumption, saving, and investment in newly produced means of production are harmonized. In real time, such harmonization of expectations is obviously never achieved, and real-world economies will always be in disequilibrium. The key question is whether the behavioral relationships which embody the expectations are dynamically stable. If they are, then the steady-state relationships between aggregate demand, aggregate supply, and the natural and money rates of interests can be seen as “magnets” (or “attractors”) toward which actual economies are drawn.
Chapter 7
Capital Values, Wealth, and Related Topics
In this chapter, I want to discuss implications of the conservation laws associated with the pool of fluid capital as they relate to asset values in an economy. Specific topics to be discussed include aggregate wealth, real-balance (or wealth) effects, the burden of government debt, taxation of capital gains, gold standards, monetization and demonetization of economies, and economic growth and deflation.
7.1
The Aggregate Wealth of an Economy
A term that has been used sparingly to this point is wealth. Wealth at the individual level can properly be viewed as the current flow of income plus the value of all real and financial assets (including Old Masters, rare stamps and coins, and other collectibles). Real and financial assets represent wealth for an individual because their value can be realized for money through sale. For an economy as a whole, however, to represent wealth as the sum total of all individual wealth involves a fallacy of composition. In a closed system, the value of real and financial assets cannot be converted to money in the aggregate because everyone would be trying to sell at the same time so that there would be no buyers.1 As we have seen, the sum total of asset values in an economy is bounded by the pool of fluid capital valued in current prices. This means, accordingly, that the aggregate wealth for an economy is simply the economy’s pool of fluid capital. Alternatively (and equivalently), aggregate wealth is represented by the current flow of income, plus existing inventories of finished goods valued at current prices. From the latter, it then follows that in steady-state equilibrium the aggregate wealth
1
The October 1987 stock market crash and the financial meltdown of 2007–2008 provide striking manifestations of this fallacy of composition in operation.
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_7, # Springer ScienceþBusiness Media, LLC 2010
79
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7 Capital Values, Wealth, and Related Topics
of an economy can be characterized in terms of the economy’s capacity to consume today without impairing its capacity to consume tomorrow.2
7.2
Money as Wealth and Real-Balance Effects
We now turn to the question of whether money is a component of wealth. Money obviously represents wealth for an individual, but to treat the aggregate stock of money as a component of aggregate wealth once again entails a fallacy of composition. Since the stock of money is created out of the pool of fluid capital, its real value (as we have seen) is clearly bounded by this pool. Hence, to include the stock of money as well as the pool of fluid capital in aggregate wealth would represent double counting.3 There is an important implication of this analysis for real-balance effects. Since the real stock of money is bounded by the pool of fluid capital valued in current prices, the stock of money cannot have a value that is independent of the size of this pool. In the aggregate, accordingly, there can be no such thing as Pigou (or realbalance) effects. There can be real-balance effects for individuals, but to posit one in the aggregate again entails a fallacy of composition. Moreover, this conclusion does not depend upon an absence of fiat money, for the total real stock of money is bounded by the pool of fluid capital, not just the real stock of inside money.4
2 This will be recognized as the Hicksian definition of income (Hicks 1946, p. 173). It also represents one of the conventional definitions of permanent income (see Friedman 1957, Chap. 3). Even with the Permanent Income Hypothesis, one nevertheless has to be wary of a fallacy of composition. For an individual, permanent income is defined by Friedman as rW, where r is an interest rate and W represents the individual’s stock of capital, including P human capital. Clearly, one cannot define aggregate permanent income as rW , where W ¼ W, because of the fallacy of composition mentioned in the text. To describe permanent income in the aggregate as rW entails nothing other than defining aggregate wealth as the capitalized value of permanent income, where permanent income is defined to begin with as the capacity to consume today without impairing the capacity to consume tomorrow. To treat aggregate wealth as something apart from aggregate income is simply to play a word game with no substance. 3 Money clearly makes an extremely important contribution to the wealth of an economy, but it does so as a social institution – an institution which facilitates exchange and reduces uncertainty, thereby contributing to a much higher level of economic activity than would be possible in its absence. However, this is the only sense that money contributes to aggregate wealth. 4 The implications of real-balance effects for individuals for equilibrium at less than full employment will be discussed in Chap. 8.
7.3 Some Implications of Old Masters as a Store of Value
7.3
81
Some Implications of Old Masters as a Store of Value
In Chap. 3 (as well as in the Prologue), we described how Old Masters can emerge as a store of value and how this value depends upon and relates to the pool of fluid capital.5 In this section, we shall consider how the existence of Old Masters as an asset affects other asset prices, interest rates, and saving and investment. To begin with, we should clarify just how it is that an Old Master, viewed strictly as a financial investment, yields a return. As already noted, since Old Masters are barren in terms of income, the yield has to result through price appreciation. Specifically, let Ph denote the price expected to obtain for an Old Master at a time h periods in the future, and let P be its current price. Then, a necessary condition for purchase of the Old Master to be attractive as an investment is for: Ph ð1 þ rÞh
>P;
(7.1)
where r represents an appropriate interest rate, for some investment horizon h. Alternatively, this necessary condition can be expressed in terms of the internal rate of return, r: P¼
Ph ð1 þ rÞh
:
(7.2)
For the Old Master to be attractive as an investment, it is obviously necessary (in the present context) for r to be at least as great as the rate-of-return on equities.6 Since, as vehicles for transferring purchasing power over time, Old Masters and equities are substitutes, the emergence of Old Masters as a store of value will clearly put upward pressure on the rate-of-return on equities, and therefore upward pressure on the natural rate of interest. While this might call forth additional saving, it might also dampen investment in newly produced means of production. Whether or not there will be upward pressure on the money rate of interest will depend upon what the sellers of Old Masters do with the proceeds. If they purchase equities, then the transaction can be viewed as exchange of Old Masters for equities. In this case, there need be no effect at all on the money rate of interest. By the same token, if Old Masters were purchased with money held as an asset, then there need not be an effect on the return to equities. Also, there need not be an effect on rates of return if purchase of an Old Master is either out of current income at the expense of current 5 Again, readers are reminded that Old Masters in this context are meant to stand for collectibles in general. 6 Whether or not investment in Old Masters turns out to be good investments ex post is obviously another question. Markets for Old Masters tend to be extremely thin, and willingnesses-to-pay for them is subject to considerable whim, fancy, and fashion. Investment in them is accordingly subject to considerable risk and uncertainty.
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consumption, or out of current saving if the proceeds are used to purchase equities (which is a case that has already been considered). If the seller of an Old Master were to hold the proceeds as money, and the reason for doing so was because of an increase in liquidity preference, both money and natural rates of interest would be subjected to upward pressure. An alternative way of analyzing the effects of Old Masters as a store of value is in terms of the impact (if any) on the pool of fluid capital. As was noted earlier, the actual creation of the Old Masters requires financing from the pool of fluid capital just as for any other good that is currently produced. Once they are created, Old Masters do not depreciate in the usual sense of the word, but they do give rise to carrying costs that are charged against current income (or, more generally, against the pool of fluid capital). When an existing Old Master is exchanged for money, this is simply an exchange of existing assets and accordingly does not affect either the pool of fluid capital or the capacity of the economy to produce. Production of Old Masters is another matter, however, and the real economy can be affected in two ways. The first is a direct effect arising from the fact that creation of Old Masters does not lead to an increase in the produced means of production, so that investment in Old Masters does not add to the economy’s capacity to generate money income – at least not in the way that investment in capacity to produce automobiles does.7 What Old Masters produce is streams of consumption enjoyment, most of which accrues to their owners without the payment of fees. The only way that Old Masters would generate money income would be if fees were charged for their viewing. Old Masters increase the psychic wealth of an economy, but not wealth as measured by the pool of fluid capital. This is because the capital expended in the original creation of an Old Master is not (in general) returned to the pool of fluid capital through charges against quasi-rents. Investment in the production of Old Masters must accordingly be seen as leading to a diminution of the pool of fluid capital relative to what it would be if the investment had been in newly produced means of production. The second way that creation of Old Masters can adversely affect the real economy is through an increase in rates of return and a possible increase in the money rate of interest. Since production of Old Masters permanently reduces the stock of fluid capital, the natural rate of interest may be increased. The largest effect, however, is likely to be on incentives to invest in produced means of production. For if firms see an increasing amount of income being spent on Old Masters, as opposed to traditional consumption goods, this may cause an increase in the required return on investment in newly produced means of production. Does it follow, therefore, that the production of Old Masters must be viewed as a drag on an economy? Obviously, this is not the case, for the emergence of Old Masters as a store of value is the result of voluntary exchange between demanders
7 I am abstracting from the fact that it takes time for Old Masters to acquire an “investment” value. At the time of actual production and purchase, an Old Master is just like any other durable consumption good.
7.4 Taxation of Capital Gains
83
and suppliers, so that welfare (as usually conceived by economists) has to be higher with their presence than in their absence. What it points out is an increasing divergence, as an economy becomes more and more wealthy, between welfare and money income. Old Masters are included in income only at the time of their production. The streams of consumption enjoyment that they produce over long periods of time do not appear as income. Economies in which Old Masters (or, more generally, works of art) acquire great money value are wealthy economies indeed, for although income does not have to be high for an Old Master to be produced, it does have to be high for Old Masters to have great monetary value. Also, the wealth of such an economy in terms of psychic welfare will be much higher than what is measured by money income.8
7.4
Taxation of Capital Gains
I turn now to questions concerning the taxation of capital, or more specifically, the taxation of capital gains. A capital-gains tax is a tax on the difference between two capital values, or more generally, between two asset values. The asset in question can be a financial asset, as well as a direct claim (i.e., ownership claim), on produced means of production. The first question I wish to address is whether in any meaningful sense, a capital gain represents income. Let us begin with the reminder that for an asset that generates income, the value of the asset is the present value of the asset’s prospective stream of quasi-rents. For an Old Master (which in general does not generate income) viewed as a store of value, the value of the asset is the discounted price that a buyer today foresees some buyer being willing to pay at some point in the future. In both cases, the capital value of the asset has two determinants: 1. The current stock of fluid capital. 2. The prospective capacity to produce (or equivalently, the prospective capacity to generate income or to command money in exchange). The current stock of fluid capital is what provides the means to pay, while the prospective capacity to generate a stream of income is what provides the motivation to purchase an asset. How is it that an existing asset can experience a gain in capital value? There are two ways in which this can happen: 1. Through an increase in the prospective stream of income (or, more particularly, an increase in the stream of prospective quasi-rents). 2. Through a decrease in the discount rate used in the calculation of present value.
8
Old Masters as examples of position goods will be discussed in Chap. 12.
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7 Capital Values, Wealth, and Related Topics
While (1) is clearly associated with increased income, the increase in asset value represents the capitalized value of this income, rather than income per se. A tax on the capital gain would accordingly represent, in part, a tax on current income (assuming that current income is included in the stream of prospective quasirents) and, in part, a tax on future income. If income is also taxed directly, then a capital-gains tax in addition to the income tax quite clearly represents a double taxation of income. On the other hand, an increase in capital value that is the result of a decrease in the discount rate does not, in any real sense, represent an increase in income at all. A tax on this component of capital gains accordingly amounts to nothing more than an increased tax on future income (because a lower discount rate increases the present value of future quasi-rents). Advocates of capital-gains taxation see capital gains as income, but this is a mistaken view. The reason that it is incorrect is that, since capital value represents the present value of future income flows, any change in capital values represents changed perceptions of these flows, either because the size of the flows are seen as changed or because the rate at which the flows are discounted is changed. A capital-gains tax is therefore a tax on future incomes. Only in small part is it a tax on current income. Moreover, the mistake is compounded by the view that capital gains represent an independent source of income. This is simply not the case, for we have just seen that capital gains derive from changed perceptions concerning future income. To tax a capital gain is potentially to tax income multiple times – before it is earned, each time a capital gain is realized, and then possibly twice more through corporate and personal income taxes (as under current tax laws in the USA) as the income is actually realized. Since a capital-gains tax is basically a tax on future income, the burden of the tax is on the owners of the current pool of fluid capital. This is because the tax is paid by those who realize the capital gain, and there is no place to which the tax can be shifted. Since the sale that realizes the capital gain involves an exchange of existing assets – money in exchange for the asset in question – the final burden has to be on the current pool of fluid capital. On the other hand, the final outcome obviously depends upon how the tax proceeds are used. If they are used for current consumption, then the final effect of a capital gains tax is in fact a consumption of capital.9 The foregoing is with reference to an income-producing asset. What about an Old Master? Suppose an Old Master is sold for a capital gain and a tax is imposed on the gain. In this case, it is very clear that the burden of the tax will again be on the current pool of fluid capital. This is because no income (in the sense of income generation) is involved in the sale/purchase of the Old Master (except possibly for some transactions fees), only an exchange of an existing asset (money) for another. The Old Master has a new value, but all that has taken place is a
9
Similar conclusions apply to the taxation of estates and inheritances.
7.5 Forced Saving and Investment
85
reshuffling of claims on the existing pool of fluid capital.10 The burden of the capital-gains tax thus must necessarily fall on the current pool of fluid capital. Consider, next, an empty parcel of land whose value has increased because it is in the expansion path of a nearby city. Suppose, in line with Henry George, that a lump-sum tax is placed on the increase in capital value. Where will the burden of the tax fall in this case? To begin with, it might seem that, because the increase in capital value arose from an externality, the current value of the land is independent of the value of the pool of fluid capital. This cannot be the case, however, because aggregate asset values are bounded by the pool of fluid capital. The increased value for the land reflects an increase in willingness-to-pay on the part of at least one party holding claims on the pool of fluid capital, an increase that could arise from either of two sources. If the pool of fluid capital has not changed since the land was originally valued, then any increase in the willingness-to-pay for the land would have to be offset by a decrease in the willingness-to-pay for at least one other asset. On the other hand, if the pool of fluid capital has increased since the land was originally valued, then an increased willingness-to-pay for the land could simply reflect this now larger pool. In short, an increase in capital value for the land has to be the result either of a reallocation of willingnesses-to-pay amongst assets or an enlargement of the pool of fluid capital. But whatever the origin of the increased capital value for the land, a lump-sum tax on a capital gain in this situation must, as with any capital gain, be paid out of the current pool of fluid capital. Since in this case the capital gain is not associated with any current flow of income, the result, at least in terms of its initial impact, will be a transfer of already existing claims in the pool of fluid capital to the government. If the tax proceeds support current consumption, then as before the tax will result in a consumption of capital.
7.5
Forced Saving and Investment
I want now to turn to an old controversy between Keynes and Robertson concerning forced saving and investment. In his 1926 book, Banking Policy and The Price Level, Robertson (who had collaborated extensively with Keynes in its writing) took as a point of departure that saving had to precede investment, or alternatively that saving had to finance investment. Saving, for Robertson, was therefore seen to consist of two components, voluntary saving, which represented the saving that would voluntarily be forthcoming (out of last period’s income) at the current rate of interest, and involuntary (or forced) saving.
10 If the Old Master now has a higher value, while no other asset has a lower value, this simply means that the current pool of fluid capital is larger than when the Old Master was previously valued.
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For Robertson, forced saving arose when current investment was larger than voluntary saving. Since investment for Robertson had to be financed by saving, the shortfall was assumed to be made up by an increase in prices that was sufficient to bid the resources needed by investment away from consumers. Keynes seemed to accept this at the time that Banking Policy was being written, but expressed himself otherwise soon after its publication. Keynes did not accept forced saving in the Treatise, and rejected it with vehemence in the General Theory. That investment has to be financed by savings is obvious, but the key point is that the savings need not be current. So long as the amount required is resident in the pool of fluid capital, investment can be funded out of past savings. This is not to deny that investment in excess of current voluntary saving can on occasion cause forced saving, only that it is not a necessary consequence.11 A view widely held in discussions related to capital theory is that capital goods are different from consumer goods.12 This is obviously true for the finished goods, but in terms of inputs the difference is much less evident. Certainly, capital goods include machine tools, electronics, and heavy equipment as inputs that consumer goods do not, but much of investment expenditure is for wages and salaries, most of which is in turn spent on consumer goods. This relates to the point made repeatedly in these pages that the pool of fluid capital funds the consumption expenditures of the labor engaged in constructing produced means of production. At the most basic level, the consumer goods that must be available to sustain the labor engaged in constructing produced means of production are food and shelter. As illustrated in the Prologue, escape from an economic state of nature accordingly clearly requires a buildup of food stocks. Shelter is more subtle, in that because of its durability, housing services can be provided from the existing stock of housing for long periods, even in the absence of current additions to the stock. Indeed, with regard to the role of shelter in investment, much of the “finance” can in principle be provided by workers themselves, especially those who own their housing outright.13 Does all of this mean that investment has to be funded by prior saving, or can it be funded by current saving as well?14 The answer to the latter is clearly yes, for it is easily seen that claims that are not exercised on current production allow goods not 11
Keynes, both in the General Theory and especially in its defense, was adamant that investment does not require prior saving. Indeed, for Keynes, investment (through adjustment in income via the multiplier) always creates an amount of saving that is just equal to the amount of the investment. As far as I can tell, however, Keynes never paid any attention to the fact that the initial funding of investment has to come out of the pool of fluid capital. In the absence of such a pool, it would seem that Keynes was implicitly assuming that the goods subsumed in investment are instantaneously produced. 12 Except when the focus is a simple one-sector growth model. 13 This paragraph clearly identifies a gray area in identifying what is to be included in the pool of fluid capital, specifically with regard to durable goods owned by consumers. These and related questions of measurement are discussed in Appendix E. 14 For Robertson, current saving is assumed to be out of last period’s income. This is now usually referred to as Robertsonian Saving.
7.6 More on Excess Monetization of Assets
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claimed to be instantaneously available to fund current investment. A decision, for example, by a couple to curb their consumption expenditures by foregoing an evening out makes the resources that they would have consumed available to a worker employed on a current investment project.15
7.6
More on Excess Monetization of Assets
Once it is accepted that the real value of the stock of tangible assets is constrained by the stock of fluid capital (valued in current prices), the dangers of loans made on the basis of tangible assets as collateral become apparent. For, in effect, this amounts to a monetization of these assets, and can (as noted in Chap. 6, and to be discussed in great detail in Chaps. 15 and 16) lead to excess monetization of the pool of fluid capital. The usual type of commercial loan may be secured by claims to produced means of production, but the claims involved are really claims against current production. So long as the amount of purchasing power that is created does not exceed the current value of the pool of fluid capital, inflation cannot be a problem (except in the sense that expectations are in error). However, if the value of assets is monetized as well as the current production that these assets produce, then (as has been noted) there is great danger that too much purchasing power will be created. The best that might happen is an inflation of asset prices. This would be the case when one asset is mortgaged to buy another asset. If the newly created money stays within the asset market, the general price level for goods will not be affected. However, money that is created for the purpose of purchasing existing assets contains the seeds of its own destruction, for asset price increases often give rise to expected future increases, which can lead to a speculative spiral which can be sustained only by a Ponzi-type scheme of finance. Once the spiral starts and new loans are made on the basis of increased capital values, the only way that interest on the loans can be paid is through further capital gains. Once the money creation stops, the bubble must necessarily burst. As the bubble bursts, asset values can fall precipitously, leading to the “destruction” of wealth. While this is a destruction of an individual’s wealth, it is not a destruction of the economy’s wealth unless something also happens that reduces the pool of fluid capital. With the deflation in asset values, there will be loan defaults. The money that would have been extinguished by the repayment of loans will remain in the economy, and in general will be held by those who were the last to sell the assets in question. The result is a transfer of real wealth (in the sense of claims on the pool of fluid capital) from banks that had loans defaulted upon and from 15 Among other things, this illustrates the point that, in terms of production, there is little difference between capital goods and consumer goods, as both require labor and intermediate goods as inputs.
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those with capital losses to holders of money. An important implication of all this is to beware of asset price inflation in a period of stagnation in the real economy, for the inflation of asset prices is almost certainly being fueled through a monetization of assets.16
7.7
Loan Defaults and the Stock of Money
As we have seen, prudent application of the Banking Principle of Money Creation implies that the amount of money created – at least on an expected value basis – will be consistent with the constraint on the real stock of money that is imposed by the pool of fluid capital. Because of uncertainty, however, some bank loans will not be repaid even with the most prudent application of the principle. In event of defaulted loans, the money that the loans originally created will obviously continue to exist. Does this mean that defaulted loans, in effect, become fiat money? Also, who ultimately bears the burden of defaults? To answer these questions, several cases have to be considered, depending upon whether collateral is involved, and, if so, whether the collateral is sufficient to cover the amount of the loan. The first (and easiest) case occurs when a defaulted loan lacks collateral and the bank has no recourse against other assets of the defaulting party. In this case, the bank would charge the loss against its capital account, but the money originally created by the defaulted loan will continue to exist.17 On the other hand, if the defaulted loan was collateralized, the pledged assets will pass to the bank and the money that was originally created by the loan will be extinguished when the pledged assets are sold by the bank. In this case, the burden will be borne by the 16 A market in which asset price inflation was spurred, at least in part, by monetization of the assets involved fine art in the late 1980s. The purchase of van Gogh’s Sunflowers by the Australian Alan Bond for $53m, for which $27m was borrowed from Sotheby’s, is a prime example. Although the loan to Bond from Sotheby’s did not involve the direct creation of money, it probably did indirectly because Sotheby’s almost certainly had borrowed the money from a bank. Coins represent still another example. The rare (and not-so-rare) coin market is sufficiently thin that a few million dollars can cause prices to shoot upward. Several rare coin funds involving upwards of $100m of “Wall Street” money were set up in the second half of the 1980s and clearly had a major impact on coin prices. Although these funds were not themselves bank financed, a number of banks started making loans to finance “investment” in rare coins. At least one of these, the West Coast Bank of Encino, CA, went under, resulting in the acquisition by the FDIC of portfolios of coins that had provided collateral for loans that had gone sour when the bubble in the rare coin market burst in 1990 and 1991. The conclusion from these last two examples is that money creation for the purpose of investing in collectibles is extremely imprudent, for the only way that collectibles (or any position good, for that matter) can earn a return is through appreciation in prices that are sustained by increases in the pool of fluid capital. 17 The only exception to this would be if the money in question were strictly a liability of the bank involved (as could have occurred in the USA in the nineteenth century), in which case the “bank notes” would eventually be presented for redemption in “lawful” money.
7.8 Crowding-Out
89
defaulter rather than by the bank. Suppose, however, that the amount obtained by sale of the collateral does not cover the original loan. In this case, an amount of money equal only to the sales proceeds from the collateral will be extinguished. The bank will charge the difference against its capital account, and this difference will also continue to exist as money. In this case, the burden of the default will be shared proportionately between the bank and the defaulter. Of the money originally created by the defaulted loan, a part will continue in existence that is equal to the difference (if positive) between the amount of the loan and the sales proceeds of the pledged collateral. If no collateral was pledged, the entire amount of the defaulted loan will continue to exist as money. Since, in normal circumstances, bank money is convertible into fiat money at the option of the holder, the money in question may therefore eventually take the form of fiat money. The conclusion, accordingly, is that the part of defaulted loans not covered by collateral can become a net addition to the stock of fiat money.18
7.8
Crowding-Out
I want to turn now to the financing of public expenditures and the insights that the present framework might have regarding “crowding-out.” Crowding-out, to recall, refers to public expenditure that is financed by debt at the expense of private investment. This view, which is periodically recycled, is most prominently associated in this century with the British “Treasury View” of the late 1920s and early 1930s.19 The standard argument regarding crowding-out is that it occurs through an increase in the rate of interest. The view seems to be that there is a fixed amount available to finance investment, the public sector has first crack, and what remains (if any) is then rationed to the private sector through a higher rate of interest. A key ingredient in this argument is the assumption (usually implicit) that investment can be financed (in a closed system) only out of current saving. To begin with, the assumption that investment (whether public or private) has to be funded out of current saving is incorrect. As we have seen, the only time when this is the case is at the time of escape from an economic state of nature. When a nonempty pool of fluid capital exists, investment can be funded from the pool even in the absence of current saving. In itself, however, this does not dispose of the crowding-out argument, for it only says that we have to focus on the total pool of 18 However, it does not follow from this that the total stock of money will necessarily be increased, for when banks obtain fiat money (i.e., currency) from the central bank their reserves are correspondingly reduced. 19 The “Treasury View” was the response of the British Treasury to the views, proposed by Keynes and Hubert Henderson in Can Lloyd George Do It?, to combat unemployment through debt-financed public works. An excellent account of the debate is given by Clarke (1988).
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fluid capital, not just on inflows into it. In assessing whether crowding-out can occur, a number of factors need to be taken into account, including: 1. How the deficit is financed 2. Whether the deficit finances public investment in produced means of production, current operations, or transfer payments to individuals 3. Effects on the money rate of interest 4. Effects on the natural rate of interest 5. Effects on the general price level There are three possible ways that a government deficit can be financed: (1) through sale of bonds to the domestic public; (2) through sale of bonds to foreign purchasers; (3) through the sale of bonds to the central bank. For now, it will be assumed that bonds are sold to the domestic public. Since the bonds are sold for money, the first question to ask is from where does the money come. Two possibilities have to be considered: 1. If the bonds are sold to the nonbank public, the money has to come from the stock of money being held as an asset. Obviously, this requires that the bonds be priced such that some individuals be willing to substitute money for bonds. Ceteris paribus, this will put downward pressure on the prices of financial assets. 2. If the bonds are sold to commercial banks, the initial effect will be to reduce the free reserves of the banking system. The banking system, accordingly, has reduced capacity to lend, therefore less capacity to create money. For bankers to be induced to buy the bonds, the price of the bonds must be low enough that banks are willing to hold them in lieu of loans. In this case, the public sector can be seen as competing directly with the private sector for use of bank reserves. If the central bank is not accommodative, the end result in either situation will almost certainly be upward pressure on the money rate of interest. The effect will be direct for the case in which the bonds are sold to banks, but indirect in the case in which the bonds are sold to the nonbank public. In the latter case, there need not be any upward pressure at all if the banking system has sufficient reserves that it does not have to raise the money rate of interest in order to attract additional reserves from the public’s holdings of money as an asset. So much for the moment about the money rate of interest, what about the natural rate of interest? Since equilibrium for the natural rate of interest can be identified with a stable general price level, I will focus the discussion in terms of the latter. What ultimately happens depends upon the impact of the public deficit on the pool of fluid capital. At this point, we need to distinguish among the uses to which the proceeds from the sales of bonds are put. There are three possibilities: 1. Investment in public-produced means of production. In terms of the effect on the pool of fluid capital, there is no difference between public investment and private investment. Both represent direct draws from the pool. If, everything else being constant, this results in upward pressure on the general price level,
7.8 Crowding-Out
91
which in turn causes private firms to reduce the amount that they invest, one can clearly identify a crowding-out effect. 2. Funding of current governmental operations (wages, salaries, etc.). This situation represents a borrowing to fund the current output of government for which there is no revenue stream (i.e., no inflow of taxes). Since consumption out of private-sector income is likely to be larger than what would be the case if taxes were larger, consumption in the aggregate is likely to be larger, which will put upward pressure on the general price level. In this case, however, price increases are more likely to be concentrated in consumption goods than in investment goods, so that investment plans of private firms may not be adversely affected. Still, this is not necessarily the case, so that once again there exists a possibility of some crowding-out. 3. Transfer payments to individuals in the private sector. This situation differs from the preceding one in that the public sector makes no purchases from the pool of fluid capital. Since (at least on Keynesian grounds) the presumption is that recipients of transfer payments have a high marginal propensity to consume, the final process can be interpreted as a loan to finance consumption. Indeed, even if the recipients of the transfers have marginal propensities to consume equal to the average marginal propensity to consume for the economy as a whole, the net effect will be a stimulus to consumption. This is because the proceeds from the sale of bonds in general are drawn from (the claims side of ) the pool of fluid capital rather than out of current income. The result, accordingly, is some likely upward pressure on the general price level and therefore possibly some crowding-out. The important point in all this is what ultimately happens to the economy’s capacity to produce. Public investment obviously leads to an increase in the stock of produced means of production and therefore to an increase in the capacity to produce. In this case, even if there is some crowding-out, it can be viewed as a substitution of public for private investment, and it is possible that public investment is the more productive. Borrowing to finance public investment is very different in this regard than borrowing to finance current government operations and transfer payments. While it may be that the stimulation to consume that the latter activities entail may induce private firms to increase investment, this is not likely. Failing this, the only way that these activities could add to the capacity to produce would be if the expenditures were to result in the creation of human capital. A conclusion accordingly seems clear: Public borrowing to finance current governmental operations and transfer payments is almost certainly a drag on economic growth. Let us now consider the situation in which the public deficit is monetized immediately through sale of bonds to the central bank. The obvious difference between this case and that in which bonds are sold to the public is a net addition from the start to the stock of money. Any inflationary tendencies will accordingly be magnified, especially in the case of transfer payments. And any crowdingout tendencies will be magnified as well. Whether or not there will be inflation
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in the circumstances depends upon how fully monetized is the pool of fluid capital. If the money created by purchasing bonds by the central bank over-monetizes the pool, there will be inflation, and this will be the case independent of the use to which the proceeds are put. For a given degree of over-monetization, however, inflation pressures will be highest for transfer payments and lowest for public investment. The final possibility is sale of bonds abroad. Since the proceeds are to be used domestically, they must ultimately be converted into domestic currency. There are obviously a number of mechanisms through which this could occur, but whichever is used it is clear that once converted the proceeds will represent an addition to the active stock of domestic currency. Ceteris paribus, this means that, as before, any over-monetization of the pool of fluid capital will lead to upward pressure on the general price level. There is one other factor to be considered, however, the possibility that any excess monetization of the pool of fluid capital will spill over onto imports. Indeed, with free trade this will almost certainly happen. With free trade and convertible currencies, the pool of fluid capital relevant to an economy is not just the domestic pool, but the pools of fluid capital of all of the economy’s trading partners.20
7.9
Burden of the National Debt
Many years ago, Franco Modigliani pointed out that the burden of the National Debt (in a closed system) on future generations is not the higher taxes they will have to pay, but rather the taxes that must be paid out of an income that may be lower than it otherwise would be.21 Actually, the debt per se is not the issue, but the uses to which the proceeds of the debt are put. If the debt funds investment in newly produced means of production (including human capital), then (assuming that the investment is productive) the capacity of the economy to produce will be increased. Income will be higher and the debt can be “repaid” from the resulting quasi-rents with no burden on the generation involved. However, if proceeds from the debt are used to fund current government operations or transfer payments, there is clearly a problem, for in general it is 20
Statements that borrowing from abroad has financed a US consumption “binge” that started in the 1980s would thus appear to have some validity. The deficit in the balance of payments during these years would appear to be a direct consequence of the Federal Government’s decision to fund current operations and transfer payments through borrowing. These decisions have stimulated consumption (at the expense of investment), and upward pressures on the domestic price level have been alleviated by a virtually infinitely elastic supply of imported consumption goods at current prices. This was possible, even with the deterioration in exchange rates vis a vis the dollar, because of strong productivity gains abroad. 21 See Modigliani (1961).
7.10 Ricardian Equivalence
93
consumption that is being funded rather than investment. Unless this somehow results in a stimulus to private investment, future generations are clearly made worse off because the capacity of the economy will be smaller than if the public debt were used to fund investment.22 This is the essential thrust of Modigliani’s point, and it is completely consistent with the framework of this book.23
7.10
Ricardian Equivalence
One of the tenets of the “New” Classical Economics is the Ricardian Equivalence Theorem – due originally to Ricardo, but most recently rediscovered by Barro (1973) – which states that, under certain conditions, the public is indifferent to whether a public expenditure is financed by debt or by taxes. The conditions are that taxpayers have an infinite horizon and that the future is discounted at the same rate of interest as applies to the debt. Under these conditions, the discounted value of the stream of future interest payments on the debt is equal to a current equivalent tax. Tobin (1980) provides a detailed critique of Barro’s analysis and conclusion, especially with regard to distribution effects (in connection with varying marginal propensities to consume) and the assumption that taxpayers discount the future at the same rate the government pays interest on the debt. Here, I want to comment briefly on a different kind of distribution effect, namely, whether public borrowing affects private investment differently than does taxation. In general, it is to be expected that a different group of people will buy bonds than would pay an equivalent amount of taxes.24 If the debt is purchased by the nonbank public, then the proceeds will be drawn from the stock of money being held as an asset, and this will tend to put upward pressure on both the natural and money rates of interest. If, on the other hand, the debt is purchased by banks, reserves of the banking system will be reduced, again putting upward pressure on the money rate of interest. In either case, private investment could be adversely affected. What, however, if the public expenditure is tax financed? The key consideration, here, is that taxes are paid out of current income and are likely to be (in part, anyway) at the expense of current consumption. This being the case,
22 A similar conclusion applies to a tax “fund” that is built up avowedly to “finance” future social security payments, but which in reality is simply used to cover what would otherwise would be a deficit in current spending. This will be discussed in Chap. 12. 23 My own view in all this is that the driving force of the problem is the continuing decisions of the Federal Government to fund consumption rather than investment. When this is juxtaposed with the anti-investment bias of the current tax system (the existence of a capital gains tax, the corporate income tax, and estate and inheritance taxes), investment clearly receives a double whammy. 24 I am assuming here that the debt is sold to the public, rather than to the central bank. I am also assuming that the public expenditure in question is for current operations rather than investment.
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there will be less upward pressure on the natural and money rates of interest than if the public expenditure is financed by debt. The conclusion thus seems to be that debt finance is more disruptive of private investment than tax finance. If this is the case, then a forward-looking economy should not be indifferent between taxation and debt finance, for there is a prospect of a larger future capacity to produce with tax finance.25
7.11
Commodity Money
The focus throughout the discussion to this point has been on bank and fiat money. Nothing really has been said about commodity money. Money, as has been emphasized, is a social invention that enables specific property rights to be converted into general property rights through the creation of general purchasing power. To state the obvious, commodity money differs from fiat money in that commodity money has value as a commodity as well as money. For concreteness in the discussion that follows, the commodity money will be assumed to be gold. The first question to ask is how it is that gold acquires a value in the first place. Just as the basis for value for bank and fiat money is the pool of fluid capital, so too for commodity money. As seen in the Prologue, gold acquires value in exactly the same way as do Old Masters: someone with claims to goods in the pool of fluid capital finds gold desirable and is willing to exchange these claims for it. If there is no fiat money in the economy, so that all exchange is by barter, a set of relative (prices) will be established, which gives the prices at which gold can be exchanged against the goods in the pool of fluid capital. If the desirability of gold is widespread, people will be willing to exchange goods for gold and gold for goods, so that gold can be used as a medium of exchange. The prices of goods in terms of gold simply become the “prices” in the economy. The important thing in all this is that gold’s value as a commodity is not intrinsic, but arises out of the pool of fluid capital, just as with Old Masters. The social invention in this case, although not as apparent as for fiat or bank money, is the implicit agreement amongst participants in the economy to use gold as a medium of exchange, and therefore as general purchasing power. Although gold is sufficiently desirable in relation to its supply that it has high value in relation to weight/volume, it is nevertheless cumbersome to carry around in large quantities, and security is required when it is held as a store of value. Gold would thus come to be stored in a secure place under lock and key, with receipts being issued to owners. With “confidence” that the amount of gold registered on the receipt could be redeemed on demand, the receipts could, and would, be used in exchange in place of the gold that they represented. These claims on money come to 25
Again, this is the case for public expenditure for current operations. The situation can obviously be different if the expenditure is for public investment.
7.12 Fluid Capital and the Gold Standard
95
function as money themselves. Since in a period of confidence little of the gold would be actually withdrawn from depositories, it is a simple step for custodians of gold to begin making loans and then to begin to function as bankers. “Reserves” in this case would be hard money, rather than central bank credit, as with bank money. Since the commodity value of gold is dependent upon the size of the pool of fluid capital, it is clear that, as with bank and fiat money, the real value of the stock of gold money is bounded by this pool, only in this case the connection is more transparent, since all of the quantities are real commodities. Yet, there should be no mistake in thinking that the connection of the stock of money to the pool of fluid capital is any less real with bank or fiat money. Concerning inflation and deflation, goods prices will rise in terms of gold whenever the pool of purchasing power represented by the stock of gold (functioning as media of exchange) is greater than the stock of goods valued in current prices. Deflation will ensue in the opposite case. Changes in the general price level thus occur in the same way with commodity money as with bank and fiat money.
7.12
Fluid Capital and the Gold Standard
I want now to examine the theory of capital and money that is being developed in these pages in the context of a gold standard. Two forms of the constraint imposed by a gold standard need to be considered. The first is where the amount of money in the economy is fixed by the amount of gold that is available – i.e., gold is the only type of money. The second form of constraint is where other types of money also exist, bank money in particular. Although the first form is clearly unrealistic, it represents an important extreme to examine. Consequently, let us assume that there is a fixed quantity of gold in an economy that somehow came to be regarded as money. There are a number of ways this might occur, but let us assume that the gold was simply imported into a previously purely barter economy. Specifically, assume that the gold was imported as payment for goods that had been exported. Payment for the exported goods by gold establishes a price for those goods in terms of gold. Through the barter exchange rates of the goods exported with the other goods in the economy, gold prices for all the goods in the economy are established as well. Since the gold represents current production that is not consumed by residents of the economy, it also represents current saving and therefore represents an addition to the stock of fluid capital (at least in terms of purchasing power). Assume that the gold immediately acquires the mantle of being money. Assume, next, that the owners/holders of the gold are besieged with requests for loans, either for investment in newly produced means of production or for the finance of current production. As loans are made in gold, the gold disperses throughout the economy and begins functioning as a medium of exchange. As economic activity proceeds, the gold prices of some goods can increase in response to increased demands, but any increases must be offset (in value) by decreases
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elsewhere. The reason for this is that the general price level was established by the gold price of the goods that were exported for the gold to begin with, and so long as the quantity of gold does not change, neither can the general price level – except possibly to decrease in the event that some goods are sold at a loss. The key point is that, with a fixed quantity of gold, the general price level cannot increase – i.e., there can be no inflation. Suppose, now, that one of the holders of gold makes a loan in the form of a slip of paper that represents a claim on gold rather than literally transferring gold to the person getting the loan. Assume that the claim begins to circulate as a medium of exchange. What are the inflationary implications in this situation? So long as both the gold and its claim ticket do not circulate simultaneously – i.e., there is a 100% gold reserve – the situation is no different than before; the general price level can go down, but can never go up. The situation will clearly be different, however, if the holders of gold were to create claim-ticket loans in excess of the amount of gold that is held. In this case, inflation is quite clearly a possibility. This situation obviously corresponds to a fractional reserve banking system, with gold acting as the “highpowered” money. At the point that gold enters the economy as payment for the goods that are exported, the general price level is established, as already noted, in terms of the gold price of the exports and the barter rates of exchange of the exports with the other goods in the economy. Let us suppose that through investment in produced means of production the economy begins to grow. What will happen to the general price level, assuming that the amount of gold remains fixed? If all loans are made in gold or claim tickets to gold with 100% reserve, it is clear that the general price level must fall, for the value of production in terms of gold cannot change (since the amount of gold is fixed), but the volume of output is increasing. The general price level has to fall.26 The important question concerning an economy with a fixed amount of gold circulating as money, is whether this will permit the economy to function properly – i.e., can both current production and investment in new capacity be financed in ways that allow the economy to grow? To deal with this question, we need to consider two cases, the first being where the stock of gold represents all of fluid capital and the second being the more normal case in which the gold is only a part of fluid capital. In the first case, it is clear that the gold is adequate to finance both investment and current production, although most probably at low levels. However, this will not be true in the second case, unless the structure of transactions were such that the gold could have a high velocity of circulation or unless there remained a lot of barter. In general, other forms of money would be needed, either in the form of a fractional reserve banking system based on the gold or in the form of trade credit or bills of exchange.
26
Obviously, this need not be the case if more gold is imported (or is produced domestically) or if the holders of gold begin to function as bankers operating under a fractional reserve.
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97
It might seem in this (the second) case that the “shortage” of gold at the prices established by the gold price of the exports (that created the gold stock to begin with) could be dealt with simply by an upward revaluation of the stock of gold (i.e., by proportional decreases in all prices). Assuming that this could somehow be done, would it work? It seems that the only way it could work would be if the economy were to be closed to external trade. For if the trade that led to the import of gold to begin with were to continue, it is hard to see how the price level could be made to fall by the proper amount, the problem being that the price level (in terms of gold) is established by the gold price of exports.27 It has been stressed repeatedly that the pool of fluid capital has two sides, a claims side and a goods side. If gold represents the claims side, what balances the gold on the goods side? Unless the gold is seen as also representing a good, there would seem to be a problem, for since the gold’s existence arose in exchange for exports, it lacks a counterpart in goods. In this case, it seems pretty clear that consistency with the definition of the pool of fluid capital that has been advanced does require that the gold be a good as well as representing a claim. Nevertheless, there still seems to be a problem, for with gold as the good that is monetized, where are the goods that the gold can come up against when it is expended? For there would appear to be a shortfall of goods in the pool of fluid capital equal to the value of the gold. If the gold were expended in a forward market – i.e., if the goods purchased are for forward delivery – there would be no need for prices to increase. However, this would not be the case if the spending were for goods for current delivery; some prices would have to go up. On the other hand, suppose that the gold were in the economy all of the time, but had never functioned as money. Owners of it had simply desired it for its beauty (i.e.,as an Old Master). Assume that via some form of social revelation, people suddenly see the use of gold as a medium of exchange to overcome the inefficiencies of barter. The first question to ask is what will determine the level of prices. If gold has previously been traded, it is clear that prices will be determined in terms of the barter exchange rates for gold. If gold has never traded, then prices will be determined in terms of the highest reservation price for exchanging gold for goods among owners of gold. The general price level in effect will be determined by the reservation supply price of a single person. As gold begins to function as a medium of exchange, it obviously acquires a use which it did not have before. In an important sense, it has become part of the economy’s capacity to produce. Its marginal (or incremental) product is the increased output that is made possible by the elimination of barter. This added output is clearly a public good.28 If gold is part 27
If the general price level should somehow be reduced, then exports would become less expensive, and there would be an influx of gold, which in turn should eventually lead to increases in the price level. 28 It should be noted that once gold starts circulating as a medium of exchange, it cannot also simultaneously continue to function as an Old Master. People can, of course, hold gold as an asset, but any return would be dependent upon changes in the general price level. The return would be negative in the case of inflation, positive in the case of deflation.
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of the economy’s produced means of production, does this mean that it is not to be counted in the pool of fluid capital? The answer is no, for being money, the gold is fluid capital par excellence. In short, gold is both produced means of production and fluid capital. Moreover, as produced means of production, gold has one exceptionally desirable characteristic – it is extremely durable and rarely has to be replaced. In addition, with gold being both produced means of production and fluid capital, the initial investment in it does not have to be charged against revenues in order to be returned to fluid capital.29 As has been emphasized throughout these pages, the pool of fluid capital provides an upper bound to the real stock of money in an economy. A gold standard does not alter this, but in the presence of prices that are inflexible downward, a gold standard can impose a bound to the real stock of money that is lower than that imposed by the pool of fluid capital. With flexible prices, the general price level can adjust so as to bring the stocks of gold and fluid capital into equilibrium with one another. With inflexibly downward prices, however, a loss of gold can result in a price level that is too high for the gold that remains in relation to the pool of fluid capital.
7.13
Demonetization and Monetization of Economies
It was just noted in connection with the gold standard that monetization of an economy is clearly a public good, in that the efficiency gains that accompany the escape from a barter system accrue to the economy at large and are shared by everyone. The flip side is that there are efficiency losses when an economy demonetizes. The standard case of demonetization is when the currency begins to break down because of inflation. As this happens, an economy (in the absence of gold or an external currency assuming the role of money) will begin to resort to barter, and productivity will necessarily fall. I now want to consider a somewhat different case, namely, the monetization of the economies of Eastern Europe following the breakup of the Soviet Union in the early 1990s. The problem that these countries had to face is usually posed in terms of moving from a socialist command economy to a capitalist one, but implicit in this is a movement from a nonmonetary to a monetary economy. It is not that money did not exist in a socialist command economy. However, its essential function was as a claim ticket to a discretionary portion of the social dividend. Because Eastern European economies saved and invested, pools of fluid capital existed, but these pools were directed to end uses (i.e., investment in produced means of production, current production, or consumption) by command, rather than through monetization and a market price system. With breakup of the Soviet system came a breakdown in 29
Gold is not peculiar in this regard. Any highly desirable form of money has this characteristic. The extreme is electronic money (i.e., numbers in accounts) which obviously never wears out.
7.13 Demonetization and Monetization of Economies
99
the command system, and institutions and experience were not in place to monetize the stocks of fluid capital and organize production and investment through marketbased price systems. Since monetization essentially had to begin from scratch, one would almost certainly have to expect a fall in productivity from what was the case in the command economies. This is almost certainly what occurred in Russia during 1991 and 1992. The problem was not an absence of money, but an absence of money in the right places. Getting money into the right places requires the creation of a banking system that will facilitate, on a prudent basis, the monetization of the pool of fluid capital.30 The loss in productivity as an economy ceases being command and begins to monetize is in principle temporary, but there is another factor to be taken into account. This is that the goods the economy is structured to produce under a centrally directed command system may not – indeed, almost certainly will not – be the goods that consumers will demand when they are able to freely choose according to their tastes and preferences. If the produced means of production cannot be converted to produce what consumers want, then there is an obvious problem, and much of the existing capacity to produce will have to be abandoned, with the capital that remains embodied in it lost forever. While the foregoing is likely a problem to some extent in Russia, what appears more so is that much of the physical capital stock of the economy is either technologically obsolete or nearly worn out (or both). Additionally, the capital embodied in it has not, through appropriate charges against production, been repatriated back into the pool of fluid capital. The capital, instead, has been consumed. In short, while the capacity of Russia to produce at the time of the breakup of the Soviet system appeared to be large on paper, its pool of fluid capital may, in fact, have been small. Let me now turn to the question of monetization of what has previously been a command economy. By monetization in this context, I have in mind both the emergence of a set of financial institutions for monetizing the pool of fluid capital and the emergence of a system of relative prices for guiding production, investment, and consumption decisions. While money and prices obviously exist in a command economy, prices are not formed on the basis of relative scarcities and consumer/ investor willingnesses-to-pay. An interesting question is how the general price level will become established in such an economy. In a western economy, a question such as this is, in general, only of interest to philosophers; price levels already exist, so that the first emergence (or creation) of a general price level is not a question of practical interest. This is not the case, however, for an economy emerging from central direction. The first question that has to be asked is whether there are any prices in the economy that genuinely reflect relative scarcities. The only real candidates for this 30
Obviously, creation of a financial system is only one of the tasks. Markets and meaningful relative (and absolute) prices must be created, and participants must acquire experience in their use. [For a discussion, see McKinnon (1991)]. This especially was the case in Russia, where a meaningful market economy last operated in 1917.
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are goods traded internationally at international prices. Traded goods will have both an internal price and an international price, but the price that really matters is the international price. All that is needed for a starter is that there be one such traded good (it does not matter whether it is an import or an export), but this is just the starter. There must also come into existence a credible primary money, by which I mean a money that not only is acceptable as money internally, but is freely convertible into foreign currency. Domestic money usually does not qualify at this point, because it is not freely convertible, so candidates are western currencies (such as the dollar, mark, or now the euro) or gold.31 Once a primary money is in place, monetization of the pool of fluid capital can begin in a meaningful manner. The primary money and domestic money must be convertible into one another at an exchange rate that is freely determined. Loans should be made in domestic currency, but the domestic currency must be convertible into the primary money on demand. It is especially important that loans be short-term and satisfy strict commercial banking criteria. As the exchange rate between domestic currency and the primary money becomes established and stabilizes, there will emerge a general price level (measured in units of domestic currency) that has really been determined by the primary-money prices of traded goods. In the circumstances, it is obvious that it will take some time (possibly even a considerable period) for relative prices to stabilize, but in general this will not affect the general price level so long as there is no change in the primary-money prices of traded goods, and there is no marked change in the domestic-currency/ primary-money exchange rate. It is important, of course, that financial institutions – specifically, a banking system based upon the primary money – come into existence and foster orderly, prudent monetization of the pool of fluid capital. Since convertible western currencies can function as the primary money, an evident institutional arrangement to consider is the establishment of a currency board. The thing be accomplished is to develop confidence on the part of Eastern European populations in their domestic currencies as money. A way of accelerating this is to take the dollar or euro or gold as the primary money, tie the domestic currency to the primary money by making gold freely convertible into the other, and then tie creation of domestic currency to holding of the primary money. Above all, the creation of domestic currency through loans must be guided by strict commercial prudence. Loans must be short-term and self-liquidating.32
31
For a detailed analysis of the points in this paragraph, see McKinnon (1991). The absence of a viable fiducial structure was especially apparent in Russia in the 1990s. Among other things, the economy lacked a banking system that allows for the funding of current production by the creation of money through self-liquidating short-term loans. As a consequence, much of the economy was barter-driven. For a discussion and analysis, see Woodruff (1999). 32
7.14 Economic Growth with Deflation: The Period 1873–1896 in the USA
7.14
101
Economic Growth with Deflation: The Period 1873–1896 in the USA
A period of US economic history that has always been fascinating to me is 1873–1896, a period of strong economic growth with steadily decreasing prices. Because economic growth combined with deflation is a somewhat unusual phenomenon, I want now to explore its accommodation within the present framework. As discussed earlier, changes in the general price level are approached in a supply/ demand framework in which supply is defined in terms of the goods embodied in the pool of fluid capital, while demand is defined in terms of the pool of purchasing power actively seeking to purchase goods and services. As noted earlier, current income, since it is implicitly valued (or measured) in current prices, cannot, in itself, be the basis for inflation, although saving that is not offset by investment can be the basis for deflation. As inflation has already been discussed, I want now to look at deflation. Let me consider first the case of where the banking system is fractional reserve, with gold as the primary money. In order to keep things simple yet realistic, assume that there are only two types of goods in the economy, agricultural products and manufactures. Assume, as was the case during 1873–1896, that productivity is increasing in both sectors. Simply as a matter of arithmetic, we know that, with increasing productivity, the growth in real income can occur through a combination of constant money wages and a falling price level, as well as through a combination of rising money wages and a constant price level. My concern is to identify a set of circumstances that allows for the former to occur. Let us consider first the case where gold is being exported in payment for imports of capital goods. With a fractional reserve banking system that is tied to gold, the import of goods necessarily means that the amount of money that the banking system can create is reduced. This means that the pool of purchasing power that confronts the goods in the pool of fluid capital valued in current prices will be less than that value. Prices will fall, but can they fall in a way that does not harm the suppliers of the goods? For harm not to occur, relative prices must not be changed. As we have seen, the general price level in an economy on a gold standard is (in the absence of excess creation of money) determined by the gold price of exports. Alternatively, we can see the general price level being determined by the gold price of imports. If gold is exported because the gold price of imports has fallen, then in order to keep the relative price of imports and domestic goods constant, the gold prices of domestic goods must fall as well – in short, there must be a general deflation, with no change in relative prices.33 The second case to be considered is where there is not an export of gold, or more specifically, where there is no foreign trade. Can growth and deflation occur in a closed economy? While the arithmetic of increasing productivity makes it clear that 33
An obvious question at this point is whether the USA was in fact exporting gold during the period 1873–1896.
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this could in fact occur, it is difficult to think of a mechanism that would bring it about, the problem being that it is not clear what the incentives would be for producers and bankers to create a reduced pool of purchasing power. With a loss of gold through exports as just considered, the amount of money that can be created is necessarily reduced, but loss of gold is not at issue in a closed economy. A mechanism that might do the trick is through productivity gains in agriculture. These could lead to lower food prices, which in turn might induce laborers to reduce money labor-supply prices, which in turn could lead manufacturers to reduce the money prices of manufactures. All of this could in principle occur without affecting relative prices. In this case, the general price level would, in effect, be determined by the gold price of agricultural goods.
Chapter 8
Macroeconomic Equilibrium and Employment
I now turn to a perennial question in macroeconomics since the time the General Theory was published: Can an economy be in equilibrium at less than full employment? Keynes’s answer in the General Theory was a clear yes. His reasoning (and mechanism) was that aggregate output and income are determined by the Principle of Effective Demand. Aggregate expenditure (and therefore income) is equal to the sum of consumption and investment expenditures, consumption (and therefore saving) is primarily determined by the level of income, investment is determined by the interest rate, and the interest rate is determined by Liquidity Preference. Savings and investment are brought into equilibrium through adjustments in the level of income, rather than through adjustments in the rate of interest. The resulting equilibrium level of output determines the level of employment, and there is no necessity for this to be at the full-employment level. Full employment could be foreclosed, for Keynes, either because of the “liquidity trap” or because of a depressed marginal efficiency of capital. Although Keynes claimed he was attacking a classical doctrine that could be traced to Ricardo, it is clear now that the doctrine he was attacking was what is at present referred to as the neoclassical orthodoxy of Walras, Jevons, and Menger, as extended by J.B. Clark, Wicksell and (in Keynes’s time) Pigou.The idea that Keynes was attacking is at base a simple one, namely, that in a competitive generalequilibrium system, all markets clear, factor markets as well as product markets. All that is required for the labor market to clear is for the capital and labor markets to be competitive and for capital and labor to be substitutable in production or consumption. The prices in question are the real interest rate and the real wage rate. The first attack on Keynes’s conclusion of a less-than-full-employment equilibrium emerged in the form of the Haberler–Pigou–Scitovsky wealth effect (or what Patinkin subsequently called the real-balance effect).1 Suppose that in an economy with perfectly flexible prices and wages the money rate of interest is in the liquidity trap, but suppose that there is a fiat money component in the stock of money.
1
See Patinkin (1948, 1965).
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_8, # Springer ScienceþBusiness Media, LLC 2010
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The real-balance argument is then that as prices fall the real value of the stock of fiat money will increase sufficiently that the consumption function will shift upward to a point where saving is reduced to equality with investment at full employment.2 The real-balance effect has been an accepted part of neoclassical theorizing for years, and because of it Keynes is viewed as simply being wrong in his conclusion that an economy could be in equilibrium at less than full employment. In my view, however, it is the neoclassicists who are in error. For, while there can be realbalance effects for individuals, extending a real-balance effect to an economy as a whole entails a fallacy of composition. As discussed in Chaps. 3 and 7, the real value of the stock of money (no matter what its origin or type, inside or outside) is constrained by the pool of fluid capital valued in current prices. Since price changes per se cannot affect the real value of this pool, a real-balance effect on the aggregate stock of money is simply impossible. Keynes may have been wrong about equilibrium at less than full employment, but not because of the existence of real-balance effects. The general-equilibrium neoclassical conclusion requires not only that there be substitution between capital and labor in production or consumption, but that there also be a negative relationship between capital and the rate of interest. The latter assumption (which was accepted uncritically by Keynes in defining the investment function in terms of the marginal efficiency of capital) has been challenged extensively by the Cambridge (England) capital theorists, most notably by Pierangelo Garegnani.3 Garegnani’s criticism takes two forms. The first is based upon the standard Cambridge (England) criticism of neoclassical growth theory, that capital can be treated as a factor of production measured in physical units. The gist of
2
See Haberler (1937); Pigou (1941, 1943, 1947); Patinkin (1965); Metzler (1951). Not only is the real-balance effect critical to equilibrium at full employment in neoclassical theorizing, but it is also viewed as being fundamental to monetary theory. According to Patinkin: It must also be emphasized that, for the simple exchange economy with which we are now dealing, the assumption that there exists a real-balance effect in the commodity markets is the sine qua non of monetary theory. For as we shall see below, in the absence of this effect the absolute level of money prices in such an economy is indeterminate: that is, no market forces exist to stabilize it at a specific level. It follows that though approximations which neglect the real-balance effect may – because of the smallness of this effect – be useful in the theory of the determination of relative prices, such “approximations” ignore a basic analytical factor in the theory of the determination of the absolute price level. Thus, whatever the justification for neglecting the real-balance effect in value theory, there can be no justification for neglecting it in monetary theory. [Patinkin (1965, p. 21).]
In the framework of this book, there is no justification for this view, for as was discussed in Chap. 6 the general price level is determined by the interaction of aggregate demand and aggregate supply, where aggregate demand is represented by the current pool of purchasing power and aggregate supply is represented by the pool of fluid capital valued in current prices. Since it is impossible (in a closed system) to have a real-balance effect in the aggregate, real-balance effects cannot influence aggregate demand and therefore cannot be a factor in determining the general price level. 3 See Garegnani (1983).
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105
Garegnani’s criticism is as follows: capital can be measured only as a value. Since a value requires prices, prices have to be determined before the amount of capital can be determined. Therefore, how can the price of capital (i.e., the interest rate) be determined jointly with other prices? This according to the Cantabridgians makes nonsense of the interest rate and real wage rate adjusting mutually in a fashion that causes the labor market to clear. In my view, this is a valid criticism. The second point of Garegnani’s criticism relates to a negative relationship between investment and the rate of interest. This point is based on the reswitching controversy of the 1960s and 1970s which occupied the capital theorists of the two Cambridges.4 Capital, in this context, is defined in terms of a book of blueprints of production techniques that employ labor and capital goods in varying proportions. A technique that is optimal at a low interest rate may be optimal again at a high interest rate, but not at intermediate interest rates.5 This means that there is not necessarily a monotonically negative relation between the amount of “capital” used in production and the interest rate (defined as the rate of return on capital). Strictly speaking, the foregoing refers to the relationship between the stock of capital (however defined) and the rate of interest, so the fact that capital and the interest rate may not be negatively related does not mean the relationship between investment and the interest rate is not negative. But Garegnani argues that this is not necessarily the case either. For present purposes, there is no need to get caught up in Garegnani’s argument, for I want to approach the questions involved in terms of the framework developed in this book.6 Within the present framework, the tradeoff between “capital” and labor in production has to be viewed in terms of the stock of produced means of production. While it is meaningful to think of this stock as representing an amalgam of capital–labor ratios, it is better, in my view, to interpret it in terms of an output–labor ratio, or equivalently as an income–labor ratio, measured as value per unit of labor. Clearly the only way that the stock of produced means of production can be altered in response to changes in the relative prices of capital and labor is through investment.7 It must be kept in mind, however, that not only does fluid capital finance investment, it also finances production. As a consequence, interest rates enter into
4 See, inter alia, the papers in the November 1966 issue of the Quarterly Journal of Economics, particularly the “Summing Up” by Samuelson. See also Harcourt (1972); Robinson (1953, 1956, 1975); Samuelson (1975); Solow (1967). 5 See Samuelson (1966) for some simple arithmetical examples. 6 It should be evident at this point that, of the two Cambridge views of capital, the concept that has been suggested in this book is closer to Cambridge, England, than to Cambridge, Massachusetts. My primary problem with Cambridge, Massachusetts, is that capital is essentially identified with the stock of produced means of production, rather than the pool of fluid capital. Cambridge, England, clearly includes fluid capital in their concept of capital, but I am unsympathetic to their method of valuation. 7 Capital is now taken to refer to fluid capital and the price of capital is assumed to be the natural rate of interest as defined earlier.
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the present value calculations driving investment decisions at two points, rather than one – in the discount factor in the denominator and as a component of short-run production cost in the numerator. This reflects that interest not only has to be paid on the purchase price of the investment but also on the short-term loans that will fund production over the lifetime of the investment. For a firm contemplating expansion of capacity, there accordingly will be a tradeoff between the amount invested in newly produced means of production and the length of the period-of-production (once the new capacity is in place). A long period-of-production can entail a substantial burden of interest, so that an increase in the rate of interest can cause a firm to shorten its period-of-production by investing in a more capital-intensive structure of production. In this case, there would be a positive relationship between investment and the rate of interest, and also between the “capital–intensity” of the produced means of production and the rate of interest.8 Let me now turn to the labor market and examine how it fits into the framework of this book. The conventional definition of the demand function for labor is in terms of the marginal revenue product that the employment of an additional unit of labor can be expected to generate. For present purposes, marginal revenue product is assumed to be measured with respect to a firm’s current period-of-production, under the assumption that the capacity to produce is fixed. In the output market, it is assumed that firms face a demand function with some elasticity and that the decision variable in determining the rate of short-run production is price. Firms are assumed to peer into their crystal balls regarding the demand functions they face, choose prices which maximize expected quasi-rents, plan production accordingly, and then make plans to purchase the necessary inputs (including labor). Maximization of quasi-rents obviously requires knowledge of short-run marginal cost curves, as these were defined in Chap. 5. The important question now is how much substitution in the short run exists between labor and other inputs. Since the overall capacity to produce is constant, there can be no substitution between labor and produced means of production for an economy as a whole, but an individual firm may not face such a constraint. Such would be the case for a firm that hires some (or all) of its productive capacity.9 For most firms, though, this is not an option, and inputs will be purchased (including labor), more or less in fixed proportions, as determined by the planned scale of production. We now turn to a derivation of the demand curve for labor. Let a firm’s quasirents be given by p ¼ R C;
8
(8.1)
The details of all of this are presented in Appendix B. An example would be a vegetable grower who can decide at the time of harvest whether to have the crop picked by hand or by machine. 9
8 Macroeconomic Equilibrium and Employment
107
where R denotes revenue and C denotes total short-run cost, as short-run cost was defined in Chap. 5. Assuming that the firm plans production so as to maximize quasi-rents, then with respect to the employment of labor, we will have for @p=@L, @R @C ¼ 0; @L @L
(8.2)
where L denotes the amount of labor employed. Assuming that labor is purchased in a competitive market, it follows that @C ¼ w; @L
(8.3)
where w denotes the money wage rate. Since R ¼ pq, where p denotes the price of output and q planned output, both with reference to the “crystal-ball” (i.e., expected) demand function, we will have @R @q @p ¼p þq @L @L @L @q @p @p þq ; ¼p @p @L @L ¼ qð1 þ p Þ
(8.4)
@p @L
where p ¼ p@q=q@p denotes the price elasticity of demand. For @p=@L, we can write @p @p @p ¼ @L @C @L @p w; ¼ @C
(8.5)
since @C=@L ¼ w. For @p=@C, on the other hand: @p @p @ðmcÞ ¼ ; @C @ðmcÞ @C
(8.6)
where mc ¼ @C=@q (i.e., short-run marginal cost). At this point, it is necessary to make an assumption as to how price is set. My assumption will be that price is set at prospective short-run marginal cost (whether in anticipation of competition, because of regulation, or whatever, is immaterial), so that
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@p=@ðmcÞ ¼ 1:
(8.7)
@p=@C ¼ 1:
(8.8)
@R ¼ qwð1 þ p Þ: @L
(8.9)
Also, @C=@ðmcÞ ¼ 1, hence,
Consequently,
This last expression represents the willingness-to-pay function (i.e., the demand function) for labor. Note that, under the pricing assumption that has been made (i.e., price equal to expected short-run marginal cost), the slope of this function depends upon the price elasticity of demand. Only in the case of an elastic demand – i.e., p < 1 – will the demand function be downward-sloping! From this, we can conclude that in an economy with both competitive product markets (so that p < 1) and competitive labor markets, the demand function for labor for the economy as a whole would seem to be downward-sloping. We can also take the supply function to be upward-sloping. Does it follow, accordingly, that the natural tendency for the economy in the short run is for the labor market to clear? To analyze this question it is necessary to derive an aggregate demand function for labor (which is not the same as the labor demand function alluded to in the preceding paragraph). To this end, refer to Fig. 8.1, which describes the short-run production decision for a typical firm in the economy. My assumption will be that the area defined by opq represents the minimum receipts that the firm feels that it has to have in order to produce an output q. The firm may see its output and price driven to q and p by prospective competition or by regulation.10 Let L represent the labor S
K
D
p s
Fig. 8.1 Typical firm’s shortrun output decision
10
D 0
q
Output
If market power were to allow the firm to entertain a feasible price above q, it may do so if this were to imply higher prospective quasi-rents. The essential point is that the firm would not intentionally plan to set a price lower than p, so that q is the maximum output the firm would plan to produce.
8 Macroeconomic Equilibrium and Employment
109
input associated with the production of q, and let R denote the associated gross revenue (i.e., opq in the figure). Hence, we can write L ¼ QðRÞ;
(8.10)
L ¼ FðR Þ;
(8.11)
for an individual firm, and
P P for all firms in the aggregate, where L ¼ L and R ¼ R. The economy’s labor market can be described by Fig. 8.2. The upward-sloping curve labeled S represents labor supply as a function of the real wage, while L* denotes the maximum amount of labor that will be demanded (as just described) for a prospective real wage w=p , where w is the money wage and p represents the price of consumption goods. In the situation described, there will be involuntary unemployment equal to L LF . The question is whether there will be forces operating to eliminate this unemployment. Assuming competition in the labor market, we can reasonably imagine that the initial effect of the unemployment will be for the money wage rate to fall, leading to a decrease in the real wage rate. This will lead to a decrease in the shortrun marginal cost curve for a firm and, ceteris paribus, to an increase in the maximum prospective output, from q to q0 in Fig. 8.3. However, for q0 to be produced price would have to fall to p0 , so that the impact on output of the initial fall in the real wage will be moderated. For a firm facing an elastic demand, the maximum prospective receipts would increase, assuming that the demand curve D is not affected. The maximum prospective amount of labor demanded would go up, however, no matter what the elasticity of demand (so long as it is not zero). Since this would appear to be true for every firm, it would seem that L* would increase and that unemployment would therefore be decreased. Generally speaking, however, goods demand functions would be affected by both the fall in the money wage and the fall in prices. Almost certainly demand functions would shift to the left, as depicted by the demand function D0 in Fig. 8.3.
L* S
w/p*
Fig. 8.2 Aggregate labor market
L*
LF
Labor
110 Fig. 8.3 Effect on output decisions due to a fall in real wages and decreased demand
8 Macroeconomic Equilibrium and Employment S
D⬘ D
S D D⬘
S⬘ q q⬘
Output
Figure 8.3 shows the new demand function as cutting the short-run marginal cost curve S at q as before, so there would appear to be no change in the maximum prospective output. This is not a necessary implication of the analysis, for there can clearly exist a q0 that lies to the right of q. If this were uniformly the case, then it would seem that the new maximum prospective employment for the economy overall could be larger than L, so a fall in the real wage could lead to an increase in employment. Still, this is not the end of the story. With reference to Fig. 8.3, the critical consideration would seem to be the size of price elasticities of demand in relation to the backward shifts in demand functions. For individual firms, price elasticity can be interpreted in terms of substitution of the firm’s product against the products of other firms, but this type of substitution obviously washes out for an economy as a whole. For an entire economy, the only form of substitution that is possible is of current consumption against future consumption. This being the case, the only way that a fall in the money wage and prices can lead to an increase in the maximum prospective employment is if firms, in gazing into their crystal balls, see consumers spending a higher proportion of their prospective incomes on consumables – i.e., if the saving rate is seen as falling. In the conventional neoclassical framework, the way that this would come about is through a real-balance effect on the stock of fiat (or outside) money, which shifts the consumption function upward to the point where saving is equal to investment at full employment. As has already been discussed, however, an aggregate realbalance effect is a will-o’-the-wisp. For, while falling prices will increase the real value of money for individuals, this cannot be the case in the aggregate because the real value of the aggregate stock of money is bounded by the real value of the pool of fluid capital. Since the real value of the pool of fluid capital is determined entirely by the goods embodied in it, its real value is therefore independent of the nominal level of prices. Even so, it might seem that if, because of individual real-balance effects, everyone begins to increase their purchases of goods, the aggregate consumption function must necessarily shift upward. This is an illusion, however. For if prices are flexible downward, they must be flexible upward as well, so that once
8 Macroeconomic Equilibrium and Employment
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additional purchasing power begins to flood into the goods market, the aggregate price level will begin to increase, and real-balance effects will operate in reverse. There is no escaping the constraint that is imposed on the real value of the stock of money. In short, there can be no real-balance effect in the aggregate. My conclusion at this point from all of this is that there are no automatic forces that are set in motion by an excess supply of labor at the existing real wage rate that will lead to a clearing of the short-run labor market. Keynes, in my view, was correct in his conclusion in this regard, and largely for the reasons that he argued.
Chapter 9
Capital Theory in Perspective
At several points in earlier chapters, reference has been made concerning the relationship of fluid capital to the capital notions of Hayek, Keynes, Schumpeter, and others. The purpose of this chapter is to examine these connections in greater detail. In doing this, I hope to provide readers not only with a better understanding of what is meant by fluid capital, but also to convince them that capital theory is still an extremely interesting and fruitful subject for research.1
9.1
Schumpeter
I shall begin with Schumpeter’s concept of money. Schumpeter at base had a credit theory of money, in that he saw most money (as a means of payment) as being generated through creation (or extension) of credit by banks. In the Theory of Economic Development, Schumpeter distinguished between normal credit and abnormal credit: Normal credit creates claims to the social dividend, which represents and may be thought of as certifying services rendered and previous delivery of existing goods. That kind of credit, which is designated by traditional opinion as abnormal, also creates claims to the social product, which, however, in the absence of past productive services could only be described as certificates of future services or of goods yet to be delivered. Schumpeter (1934, p. 101). 1 The current younger generation of economists, at least on the US side of the Atlantic, might think that conceptual problems involving capital have been solved, comfortable with the idea that capital is simply the argument “K” in the aggregate production function. In my opinion, this is an incorrect reading of what finally emerged from the capital controversy of the 1960s and 1970s. Despite the apparent agreement on reswitching, Cambridge, USA, no more convinced Cambridge, UK, of the correctness of its position than Cambridge, UK, convinced Cambridge, US. Moreover, as has been pointed out by Mirowski (1989, Chap. 6), the concepts of capital of the two sides were simply too incompatible for there to have been any meaningful compromise. What happened (at least in my view) was that both sides simply tired of the debate, and went on to other things.
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_9, # Springer ScienceþBusiness Media, LLC 2010
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Schumpeter always viewed credit as the creation of generalized purchasing power, which enabled resources to be transferred to the hands of entrepreneurs for the creation of new combinations of production. For Schumpeter, the creation of credit was absolutely essential for economic development. Additionally, he makes the point that, in principle, the entrepreneur is the only one who needs credit.2 The businessman has purchasing power (and therefore resources) flowing towards him through the sale of product, but this is not the case for the entrepreneur. The only way that the entrepreneur can acquire resources is through the creation of new credit granted to his control. This is the abnormal credit referred to above. By its nature, this type of credit cannot be secured by a flow of current goods (as with normal credit), but is secured by future goods. This does not mean that credit granted to entrepreneurs may not be secured by existing assets, but even if it were, the credit is nevertheless unsecured in terms of current output.3 The point of departure for Schumpeter (in the Theory) was always a circularflow equilibrium, which was assumed to be at full employment. Since the economy is at full employment, entrepreneurs can get the resources needed to effect new combinations only by bidding them away from existing uses with the newly created entrepreneurial credit. This results in what Schumpeter referred to as “forced saving.”4 With the economy at full employment, the bidding away of resources by entrepreneurs requires an increase in prices. The inflation, however, is only temporary, since prices will fall once the output from the new combination of production comes into the market. Indeed, the price level, once equilibrium is reestablished, will actually be lower than before because of the increased productivity of the new combination.5 Schumpeter’s essential point concerning entrepreneurial credit is that credit is necessary for an entrepreneur to acquire the resources to effect new combinations. As he puts it, the entrepreneur has no prior claims on resources within the current circular flow and credit acquisition is the only way that he can obtain the purchasing power to bid resources away from their existing uses.6 Schumpeter viewed money as a “claim ticket” to a portion of the social dividend. His analogy was to the claim 2
Schumpeter (1934, p. 102). Schumpeter notes (Theory, p. 101) that the entrepreneur may mortgage goods acquired with the newly created purchasing power, but there is still a time interval, if only an instant, in which the entrepreneur’s credit is unsecured. 4 Since the Theory was first published (in German) in 1911, Schumpeter’s concept of forced saving clearly predated the debate between Keynes and Robertson regarding forced saving. 5 It should be noted that if the economy is at less than full employment when credit is created to finance a new combination, forced saving is not necessary because the resources to be transferred to entrepreneurs can come out of existing stocks. Moreover, there is no necessity of a temporary increase in prices. Since Keynes saw unemployment as the norm, this is obviously an important difference between Schumpeter and Keynes. 6 The only problem I have with Schumpeter’s view regarding the creation of entrepreneurial credit is the implication that purchasing power cannot be borrowed, but must be created de novo. This was necessary for Schumpeter because of his assumption that innovation always begins from a position of full employment. 3
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on space in a theater that a ticket holder has to a play to be given in the theater.7 For Schumpeter, the key thing about entrepreneurial credit was the creation of purchasing power where none had previously existed. He did not view the money that is created through the monetization of bills of exchange, bills of lading, etc., as the creation of new purchasing power, but only as monetization of purchasing power that already exists in the circular flow.8 Turning now to Schumpeter’s concept of capital: Capital is nothing but the lever by which the entrepreneur subjects to his control the concrete goods which he needs, nothing but a means of diverting the factors of production to new uses, or of dictating a new direction to production. Schumpeter (1934, p. 116). The function of capital consists in procuring for the entrepreneur the means with which to produce. It stands as a third agent necessary to production in an exchange economy between the entrepreneur and the world of goods. It constitutes the bridge between them. It does not take part directly in production, it is not itself “worked up”; on the contrary it performs a task which must begin before technical production can begin. Schumpeter (1934, p. 117).
Schumpeter’s concept of capital is very similar to the one that is used in this book – similar, yet not the same. The concept of capital employed in this book is that capital is a surplus consisting of all goods in process of production plus all stocks of finished goods. This is what has been referred to as (the goods side of) the pool of fluid capital. For Schumpeter, on the other hand, capital consists of the ability (as represented by newly created purchasing power) to divert resources contained in the pool from existing uses to new uses. Schumpeter’s concept of capital is thus a disequilibrium concept in that capital exists only when resources are being diverted from existing uses to new uses. My concept of capital is a stock that exists at all points in time (although it can obviously be undergoing change). The relationship between the two concepts of capital is that my concept represents the pool from which Schumpeter’s capital is drawn. Let me now turn to Schumpeter’s treatment of interest. In Schumpeter’s scheme, investment is undertaken because of the prospect of making a profit. In order to acquire the capital necessary to effect the new combination, interest has to be paid to the bank which creates the entrepreneurial credit. The interest is paid out
7 At various points in his writings, Schumpeter extended his concept of “claim ticket” to income by viewing income as representing a pool of claims to the social dividend. This characterizes the definition of income adopted in this book. 8 At his death, Schumpeter left an unpublished manuscript on money, which was subsequently published in German (Schumpeter 1970). As far as I know, the only part of this book that has been translated into English is the editor’s introduction. This is found in a Ph.D. thesis by Michael Reclam (1984) at the University of California at Riverside. See also McCraw (2007, p. 155, footnote 11).
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of the profit. Profit disappears, however, once the economy settles into a new circular-flow equilibrium, which means that, for Schumpeter, the equilibrium rate of interest is zero.9
9.2
Keynes
In essentials, Keynes had much the same view of money as Schumpeter, in that he saw most money as being created by banks through the extension of loans.10 Keynes had virtually no discussion of how money was created in the General Theory – the stock of money was treated as exogenous, controlled by the monetary authority – so that Keynes’s most developed views on money are to be found in the Tract on Monetary Reform and the Treatise on Money. However, Keynes’s view of money that is of most interest for present purposes is the one implicit in his discussion of the “finance” motive for holding money. In one of his 1937 Economic Journal articles, Keynes states: . . . the finance required during the interregnum between the intention to invest and its achievement is mainly supplied by specialists, in particular by the banks, which organize and manage a revolving fund of liquid finance. . . . For “finance” is essentially a revolving fund. It employs no savings. It is, for the community as a whole, only a bookkeeping transaction. As soon as it is “used” in the sense of being expended, the lack of liquidity is automatically made good and the readiness to become temporarily unliquid is available to be used over again. Finance covering the interregnum is, to use a phrase employed by bankers in a more limited context, necessarily “self-liquidating” for the community taken as a whole at the end of the interregnum period. Keynes (1937b, p. 615).
And then in an oft-quoted passage later in the same article: This means that, in general, the banks hold the key position in the transition from a lower to a higher scale of activity. If they refuse to relax, the growing congestion of the short-term loan market or of the new issue market, as the case may be, will inhibit the improvement, no 9
This is in marked contrast to Keynes, for whom the rate of interest was determined, in normal circumstances, by the unwillingness of individuals to give up the liquidity of money. In assessing this difference between Keynes and Schumpeter, however, it must be kept in mind that their two points of reference are very different. Schumpeter’s equilibrium was a stationary state in which the circular flow endlessly repeated itself, and there was no uncertainty. In disequilibrium – i.e., when investment was occurring – when the interest rate for Schumpeter is nonzero, there is not much difference between their two views on interest. Also, in the very long run, Keynes had the marginal efficiency of capital falling to zero, which, in the absence of uncertainty, would imply a zero rate of interest as well. 10 In general, Schumpeter had a very critical view of Keynes. He had admiration for the Treatise on Money, but none at all for the General Theory. Schumpeter undoubtedly viewed Keynes as his rival as the “World’s Greatest Economist,” whereas Keynes did not reciprocate. I doubt that it ever crossed Keynes’s mind that the world’s greatest economist was anyone other than himself!
9.3 Irving Fisher
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matter how thrifty the public purpose to be out of their future incomes. On the other hand, there will always be exactly enough ex post saving to take up the ex post investment and so release the finance which the latter had been previously employing. The investment market can become congested through shortage of cash. It can never become congested through shortage of saving. This is the most fundamental of my conclusions within this field. Keynes (1937b, pp. 618–619).
While Keynes’s focus in the article from which these passages come was on the equality of saving and investment, it is clear that, in seeing “finance” as a revolving fund that is created and extinguished independently of saving, his views of money and money creation are similar to those adopted in this book. If the concept of “finance” is extended to the financing of current production, as well as to the “interregnum” between the intent to invest and its achievement, then the “revolving fund” in question can be interpreted in the present context in terms of the stock of transactions balances. The only essential difference between Keynes’s view of money in these passages and that of this book is that Keynes appears to make the “revolving fund” independent of all saving, past as well as current. In this book, the revolving fund can be independent of current saving, but not of past saving, because an existing pool of savings must be in existence in order for monetization to occur. Like many, Keynes employed a variety of concepts of capital in his arguments, usually without formal definition or explanation. The precise meaning was meant to be supplied by the particular context. In the General Theory, he seemed to slip back and forth between capital as working capital and capital as physical capital, depending upon whether reference was to finance or to investment. In the Treatise, on the other hand, capital most of the time appears to refer to working capital. As Keynes was a pragmatist at base, I do not think he ever really concerned himself with the question of what capital is. To him, it was simply a fact that capital existed, and how it was to be defined and treated was to be determined by the question at issue. Keynes nowhere seems to work with the concept of fluid capital as defined in these pages, yet fluid capital would seem to be implicit, as just noted, in his discussion of the “finance” motive for holding money.
9.3
Irving Fisher
Let me now turn to Irving Fisher, who is generally acclaimed to be the premier capital theorist of the 20th century. In The Nature of Capital and Interest, Fisher defines wealth as anything material that is owned. Capital is then defined as the stock of wealth at a point in time, while income is defined as the flows of services generated from wealth. Fisher’s definition of capital is thus extremely broad, in that anything that generates a service which yields a benefit (whether paid for or not) is viewed as capital. In general, I find Fisher’s confounding of capital with capital value to be unsatisfactory for at least four reasons: 1. The stock of capital becomes dependent upon the discount rate used in calculating present values.
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2. Capital is treated as unrealized future consumption. 3. Any distinction between the capital expended in creating produced means of production and capital value of the latter is foreclosed. 4. Finally, foreclosed, too, are conservation laws imposed by the stock of fluid capital on the total of capital values and the real stock of money. Since produced means of production are durable, today’s stock of produced means of production will obviously also be capable of producing output and income tomorrow. But it is not useful, in my view, to interpret this capacity to produce tomorrow as deferred consumption. And it makes no sense at all, in my opinion, to measure this deferred consumption in terms of capital value. While the present value of an existing capital good depends upon future quasi-rents, which clearly depend upon expected future incomes, the actual willingness-to-pay depends upon current income, except in the case of a bank or other lender willing to lend on the basis of the expected future income.11 In my view, it is much better to distinguish between fluid capital and produced means of production, and then to see the stock of produced means of production (in conjunction with the pool of fluid capital) as determining the current capacity to produce and the facility to generate income. Fisher’s concept of capital might have merit in terms of describing the wealth of an individual, but it is too inclusive to be usefully applied to an entire economy.12
9.4
Bo¨hm-Bawerk
In the first several chapters in Vol. 2 of the Positive Theory of Capital, Bo¨hmBawerk reviews and critiques a number of concepts of capital in the literature, and also offers and defends his own definitions. Specifically, he defines capital as: Let us call capital, in general, an aggregate of products which serve as a means of acquiring goods. Bo¨hm-Bawerk (1959, p. 32).
Later, Bo¨hm-Bawerk identifies capital as consisting of intermediate goods. The more intermediate goods that are employed in production, the more capital that is
11
And even in this case, it would seem that (in normal circumstances) the ability to lend is constrained by current income (or more generally by the current pool of fluid capital). 12 Before leaving this discussion of Fisher’s concept of capital, it is interesting to note that, at one point in The Nature of Capital and Interest, Fisher describes capital in terms of the stock of all goods in existence. Assuming that this includes goods-in-process as well as finished goods, it corresponds to the goods side of the pool of fluid capital as defined in this book.
9.5 Jevons and Wicksell
119
used, and the more indirect – or roundabout – is production.13 In general, what Bo¨hm-Bawerk calls capital is what I have referred to as physical capital or produced means of production. However, Bo¨hm-Bawerk is also adamant at one point in stating that saving must precede the formation of capital, but then sees capital as arising out of both saving and production.14 In doing this, he very clearly merges fluid capital and produced means of production. While Bo¨hm-Bawerk identifies capital with intermediate goods, he does not distinguish between capital embodied (or sunk) in produced means of production and capital that has a counterpart in goods-in-process and stocks of finished goods. By distinguishing produced means of production from fluid capital, we are able to understand and keep separate, in a fundamental way, the two most important attributes of capital: (1) its contribution to enhanced production and (2) its fluidity or ability to flow from one use to another. Capital that is embodied in produced means of production is not fluid. It becomes fluid only as it is recovered through charges against revenues. By not distinguishing between sunk and fluid capital, Bo¨hm-Bawerk does not allow for these mechanics of capital formation – i.e., that capital is not only initially formed through saving, but is “reformed” through myros recovery charges against quasi-rents. Also, Bo¨hm-Bawerk’s definition of capital does not allow for us to see in a straightforward way that not all capital (in Bo¨hm-Bawerk’s sense) is mobile – only fluid capital (and produced means of production which are perfectly fungible) is mobile. Bo¨hm-Bawerk’s concept of capital also does not allow in a transparent way for the fact that current production in general must be funded out of the pool of fluid capital, not just investment in newly produced means of production. Capital embodied in produced means of production cannot do this. Finally, a last benefit of separating physical and fluid capital is that it allows for the proper place for money in an economy, in that it allows one to see that money (or, more properly, monetization) is tied to the pool of fluid capital, rather than the total of physical and fluid capital.
9.5
Jevons and Wicksell
I now turn to Jevons and Wicksell, whose notions of capital (along with those of Hayek), as noted in Chap. 2, clearly inspire the conception of capital that is advanced in this book. In the Theory of Political Economy, Jevons states: . . . Capital, as I regard it, consists merely in the aggregate of those commodities which are required for sustaining laborers of any kind or class engaged in work. A stock of food is the 13 There is a tendency in the literature to equate roundaboutness with the period of production and to associate more roundabout techniques with a longer period of production. This is a mistake. Although Bo¨hm-Bawerk, himself, seems guilty of this at times, his intent, it is pretty clear, was to identify roundaboutness with division of labor, which in most cases leads to a shortening, rather than a lengthening, of the period of production. 14 Bo¨hm-Bawerk (1959, p. 102).
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main element of capital; but supplies of clothes, furniture, and all the other articles in common daily use are also necessary parts of capital. The current means of sustenance constitute capital in its free or uninvested form. The single and all-important function of capital is to enable the laborer to await the result of any long-lasting work – to put an interval between the beginning and the end of an enterprise. Jevons (1871, pp. 223–224).
In Interest and Prices, Wicksell commented on this conceptualization of capital by Jevons as follows: Fundamentally this line of approach is certainly correct. But Jevons commits the error of confusing the part with the whole. Even if it is agreed that fixed capacity is merely the temporary product of labor and free capital, the costs of production which are advanced out of the latter can never be resolved entirely into wages. The rewards of the other factors of production, and particularly of land, must be taken into account. . . . Capital in its “free and uninvested form” consists not only of the means of sustenance by which laborers can defray their consumption, but it also provides for the owners of other factors of production, above all for the owners of land. In its essence it is not merely a “wages fund” but also a “wages and rent fund.” Wicksell (1936, pp. 122–123).
Wicksell is surely correct in his criticism of Jevons, in that production obviously requires expenditures for inputs other than labor. If Wicksell’s “wages and rent fund” is interpreted to include provision for the intermediate goods used in production, it is clear that Wicksell’s conception of capital in “free and uninvested form” is essentially the same as the concept of fluid capital of this book. Despite this apparent equivalence, “free and uninvested” capital does not play the role in Wicksell’s analysis that fluid capital does in this book. Specifically missing from Wicksell’s analysis is a functional separation between the goods side of “free” capital and the claims side. By not making this distinction, Wicksell (in my view) was led to too narrow a conception of the market (i.e., the “capital” market) in which the natural rate of interest is determined. In this book, the natural rate of interest is determined in the market which transfers claims on the pool of fluid capital from suppliers to demanders. For Wicksell, in contrast, determination of the natural rate of interest is confined to the market for saving and investment. No account is taken of the supply of claims from past saving or of demands arising from the need to fund current production. Moreover, Wicksell’s analysis also does not take into account the macroeconomic constraints that the stock of “free” capital imposes on capital values and the real stock of money.
9.6
Capital as Embedded (or Stored) Labor
It is common in capital theory to interpret physical capital as representing embodied, or stored, labor. Saving is similarly viewed as representing deferred consumption. The deferred consumption is then ultimately seen as being produced by the labor that
9.7 Capital Theory as the Economics of Time
121
is “stored” in the physical capital. In my view, this is not a useful conception of what physical capital represents, for among other things it encourages the overly sophisticated treatment of depreciation that is now an integral part of capital theory. In the framework of this book, depreciation is viewed simply as a device whereby the capital embodied in physical capital is returned to the pool of fluid capital through charges against revenues. The current conventional view in economics, however, is that depreciation is an element of cost.15 Included in depreciation (at least in the view of many) will be a return to capital, so that, inter alia, optimal economic depreciation will make investors whole on the original investment. I do not mean to imply by this that optimization with regard to depreciation is not a meaningful concept. Since there are many depreciation schemes that can, in terms of out-of-pocket cost, make an investment whole, it is perfectly reasonable for a firm to choose the one that is in some sense best. But I think it is misguided to identify optimal depreciation with the “correct” definition of long-run marginal cost, which then becomes the basis, in some contexts, for a socially optimal price.16 As discussed earlier in these pages, long-run marginal cost drives investment decisions and is relevant in guiding pricing in long-term contracts, but is not relevant to decisions regarding current output and pricing. The idea that price at times (specifically, during times of peak demand for goods and services subject to time-varying demands) should reflect a depreciation component (unless the price is negotiated in a long-run contract) is simply wrong in my view. If the expectations that drive an investment in the first place are in fact realized, then the investment will be made whole through the quasi-rents that the investment generates. Long-run marginal cost is reflected in the price that is paid for the investment, not in the quasirents the investment is expected to generate. The present value of these quasi-rents must, for the investment to be pursued, be at least as great as the price (or cost) of the investment. That is all. Once the investment is undertaken, one cannot then turn around and reinterpret the quasi-rents as depreciation. Depreciation (in the form of myros recovery charges) will be charged against the quasi-rents in repatriating the fluid capital that was originally embodied in the investment back into the pool of fluid capital, but quasi-rents are not depreciation per se.
9.7
Capital Theory as the Economics of Time
Related to the foregoing is the widely shared view amongst current-day capital theorists that capital theory, at base, is simply the economics of time. Hirshleifer, for example, characterizes capital theory as the optimal intertemporal allocation of resources,17 while Samuelson, similarly but a bit more narrowly, describes “what 15 16 17
See Baumol (1971). Cf., also, the discussion in Chap. 2 above. See Turvey (1968, Chap. 8). Hirshleifer (1970).
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used to be loosely called capital theory” in terms of the economics of “time-phased production.”18 However, of all the modern neoclassical capital theorists, the one who probably has focused most deeply on the question of the “proper scope of capital theory” is Robert Solow. In his de Vries lectures in 1963, Solow states: There is a highbrow answer to this question and a lowbrow one. The highbrow answer is that the theory of capital is after all just a part of the fundamentally microeconomic theory of the allocation of resources, necessary to allow for the fact that commodities can be transformed into other commodities over time. Just as the theory of resource allocation has as its “dual” a theory of competitive pricing, so the theory of capital has as its “dual” a theory of intertemporal pricing involving rentals, interest rates, present values and the like. The lowbrow answer, I suppose, is that theory is supposed to help us understand real problems, and the problems that cannot be understood without capital-theoretic notions are those connected with saving and investment. Therefore the proper scope of capital theory is the elucidation of the causes and consequences of acts of saving and investment. Where the highbrow approach tends to be technical, disaggregated, and exact, the lowbrow view tends to be pecuniary, aggregative, and approximate. A middlebrow like myself sees virtue in each of these ways of looking at capital theory. I am personally attracted by what I have described as the lowbrow view of the function of capital theory. But as so often happens, I think the highbrow view offers indispensable help in achieving the lowbrow objective. In particular, the suggestion that capital theory is an extension of ordinary resource allocation and price theory reminds one that modern microeconomics has two aspects which might be called the descriptive and the normative. . . . Capital theory, too, has a technocratic and a descriptive side. I believe that the easiest and safest route to a simple but rigorous view of the subject is to begin technocratically. By asking planning questions, allocation questions, we, as I hope to show, dodge many embarrassing questions of definition and ideological overtones. . . . Solow (1965, pp. 14–15).
After additional discussion, Solow then states: Thinking about saving and investment from this technocratic point of view has convinced me that the central concept in capital theory should be the rate of return on investment. In short, we really want a theory of interest rates, not a theory of capital. Solow (1965, p. 16).
By focusing on the rate of return on investment, one is able (according to Solow) to avoid: . . . most or all of the real or imaginary “problems” that have beset this branch of economics for so long. In particular, to calculate the rate of return in my sense requires no measurement of the stock of “capital.” What is more, a careful person will see that the whole process can be described without even mentioning the word “capital.” Solow (1965, p. 25).
Solow’s conviction that one can banish “capital” from the lexicon is illusion in my opinion, for a well-defined concept of capital is never far from the surface in 18
Samuelson (1976, p. 11).
9.8 Capital Accounting
123
Solow’s analysis. That this is the case is evident when he follows the above passage with: If there are concrete capital goods, or inventories, or delay periods, these will all of course affect the rate at which bundles of current consumption goods can be transformed into bundles of future consumption goods. But unless it is a natural thing to do under the technological circumstances there is no need to identify or measure a stock of generalized capital. If the economy throws up market prices or if the process of analysis yields some kind of efficiency prices, then there is no harm in adding up various value sums which may correspond to the market (or other) value of the stock of capital goods. But such value sums are not “capital” in the sense of something that belongs in a production function and has a marginal product. . . . I am content with the point that the problem of measuring “capital” simply does not arise in my way of looking at the theory. Solow (1965, pp. 25–26; italics added).
There is one overarching problem with the (highbrow) neoclassical view that capital theory is the extension of ordinary price theory to intertemporal allocation of resources and consumption. This problem is that it requires that capital, however defined, be a substance whose value is conserved over time. Fluid capital, as it has been defined in this book, clearly has a substantive dimension, in that, on the one hand, it consists of goods. On the other hand, it also has a value dimension, in that its components can be aggregated only as values, so that fluid capital can be represented only in the aggregate as a value. As we have seen, the aggregate value of fluid capital imposes a variety of constraints on macroeconomic activity, so that fluid capital can certainly be seen to be conservative at a point in time. However, it does not follow from this that fluid capital is conservative over time. For this to be the case, it would be necessary either (1) that a substance theory of value be in place or (2) that the tastes and preferences determining individual values be time-invariant. Since neoclassical price theory is based upon a subjective field theory of value, (1) is clearly rejected. As for (2), it was argued earlier in this book that there is simply no way in the real world that this condition can ever hope to be satisfied.19 Neoclassical capital theory accordingly contains an unremovable inconsistency: in order for capital to be treated as a substance that is conserved over time, a substance theory of value is required, but value in neoclassical price theory is determined subjectively.20
9.8
Capital Accounting
In my view, much of the confusion involving capital and capital-related concepts can be alleviated through the development of an appropriate framework for capital 19
See Appendix A. That neoclassical growth theory is bedeviled by a fusing of inconsistent theories of value is discussed in detail by Mirowski (1989, Chaps. 5 and 6). 20
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accounting. By an accounting framework for capital, I simply mean the establishment of a set of simple rules for describing the evolution of capital in response to behavioral decisions which add to or subtract from its quantity. As noted at the outset of this book, the literature contains many concepts of capital, with the same author often mixing them in vague and inconsistent ways. My approach throughout this work has been to distinguish among three types of capital: 1. Produced Means of Production, which comes into being through investment and combines with permanent resources and labor to define an economy’s capacity to produce goods and generate income. 2. The Pool of Fluid Capital, which can be viewed as representing two equivalent stocks. On one side it represents, at any point in time, the stock of goods in existence, at all stages of production, both consumables and physical capital goods, measured in current prices.21 On the other side, it can be seen as consisting, again at any point in time, of the uncommitted residue from past savings – i.e., the uncommitted surplus of an economy – again valued in current prices. 3. Financial capital, which in general represents the current market valuations of the property rights in the stocks of produced means of production and fluid capital. The focus throughout the discussion has been on the pool of fluid capital, for this is the critical quantity that drives any economy, no matter what its social and political structure or how its economic activity is organized. An economy simply cannot grow in absence of enlargement of this pool through saving and investment from it in produced means of production. The pool of fluid capital is what allows produced means of production in one form to be transformed into another form. It is the “putty” of the “putty-clay” discussions of the 1960s and 1970s. The capital originally expended on produced means of production is recovered back into the pool of fluid capital through (myros recovery) charges against quasirents generated by the produced means of production. As has been noted, the timing of these charges is discretionary. A firm with a short investment horizon (for whatever reason) will insist upon the prospect of much larger early-on quasi-rents than a firm with a long investment horizon. It is to be emphasized that the decision as to timing of myros recovery charges does not bear any necessary relationship to “economic” depreciation as this term is usually understood by economists.22 “Economic” depreciation refers to changes in capital values, and is therefore prospective, whereas the “depreciation” at issue here refers to the recovery of fluid capital that has been expended in the past. What matters for capital recovery is that the quasi-rents envisioned at the time the capital was invested be more-or-less
21
The physical capital goods in reference are those in inventory, not those already in situ through investment. The latter are represented in the stock of produced means of production. 22 Cf. the discussion in Chap. 2.
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realized on schedule, not the current valuation of the quasi-rents yet to be realized. A substantial increase in the discount rate used in valuing these quasi-rents can make their “present value” look small – and therefore “economic” depreciation large – even though the actual size of the quasi-rents are totally on track with what was originally envisioned. The foregoing emphasizes the importance of deriving an accounting framework to accurately record the capital structure of an economy. Five accounts are needed: 1. An account recording the pool of fluid capital 2. An account recording the stock of undepreciated produced means of production23 3. An account recording the flow into the pool of fluid capital from saving out of current income 4. An account recording the flow into the pool of fluid capital through myros recovery charges against current quasi-rents 5. An account recording the flow out of the pool of fluid capital through investment in newly produced means of production All entries in these accounts are values. As has been emphasized throughout this book, there should be no pretense that capital is to be represented in the accounts as a physical quantity. Accounts 1, 3, and 5, will be in current prices, while accounts 2 and 4 will be in historical prices (i.e., a dollar is a dollar no matter what point in time the investment was made or the myros recovery charge was taken). In general, the capital-accounting framework just outlined is pretty much in line with standard accounting practices, but only at the micro level (i.e., for firms). The focus here, however, is macro, specifically on the pool of fluid capital. I am not aware of any country that attempts to measure this quantity. Some countries have capital accounts in their national accounts, but the focus is on produced means of production, rather than fluid capital. The USA has no official capital accounts at all. The absence of capital accounts is unfortunate, for by not focusing on the pool of fluid capital, bad things can be happening to an economy’s stock of physical capital without policymakers even being aware of it. A case in point may be the recurrent debate in the USA concerning the state of the public physical capital stock (as represented in bridges, highways, streets, water, and sewer systems, etc.). In principle, there is no difference between public and private physical capital in an economy. Investment in both must come from the pool of fluid capital, and both can be recovered only through charges against current income. For private firms, this is done simply as a matter of fiducial prudence through charges against quasi-rents. For public physical capital, however, this is generally not the case, for in general there are no public quasi-rents to make myros recovery charges against. Proper capital accounting would require the establishment of capital sinking funds to be
23
By undepreciated, I mean original cost of investment minus accumulated myros recovery charges.
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charged against general tax revenues, but this is almost never done. The result may be that the USA in recent decades has, indeed, been consuming its public capital.
9.9
Capital and Nonrenewable Natural Resources24
At the start of this work, capital was defined as temporary resources, as opposed to permanent resources (such as land and basic labor). This leaves up in the air how nonrenewable natural resources, such as minerals, are to be treated. Consider an oilfield. Assume that the oilfield has been developed so that it is ready to begin producing oil, but production has not yet started. The field is expected to contain one billion barrels of recoverable oil. What is the capital represented in this oilfield and how is it to be treated in the capital account? To begin with, it is clear that every dollar spent, for whatever reason, including interest, in developing the oilfield represents investment of capital from the pool of fluid capital, and it is obviously expected that these expenditures will be returned to the pool through charges against quasi-rents. The question really concerns the one billion barrels of oil to be pumped from the field. Once the oil is pumped and consumed, it is gone forever. Should this loss also be charged against quasi-rents? In my view, the answer is no. For one thing, it is not clear just what the capital would be that is to be charged off. Some would advocate using economic depreciation (i.e., the difference in the present values of the prospective quasi-rents between not pumping the oil and pumping), but this would make the amount to be charged a function of (among other things) the interest rate used in calculating the present values.25 As I see it, there should be no charges against quasi-rents for the disappearance of the oil because, with regard to the oil as such, no fluid capital was expended in bringing it into existence. The oil per se is a gift of nature, just like land. The only difference is that oil depletes. However, what about the case where the oilfield is sold to another firm just before it begins to produce? The oilfield clearly has a capital value, so does this value not represent an expenditure of capital? Again, in my view, this is not the case, for the development expenditure of the oilfield will be included in the supply price of the field, and therefore will be expected to be recouped by the original developer in sales proceeds. The new owners of the oilfield will expect to have their investment made whole through the stream of prospective quasi-rents, but (once the development costs are recovered) the pool of fluid capital will be no smaller once the oilfield is depleted than what it would have been if the oilfield had never been
24 For a detailed elaboration of the points in this section with reference to nonrenewable natural resources, see Taylor (1998). 25 The case where the oilfield is sold after development, but before production begins, will be considered in a moment.
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discovered in the first place. Should the new owners decide that they want to remain in the oil business after the field is depleted, they will set up a sinking fund to be funded by “depletion” of the oilfield. These depletion charges will clearly be additions to the pool of fluid capital, so that in this case the pool will be larger after the oilfield is depleted than what it would have been had the field never been discovered. The conclusion, therefore, is that depletion reserves on nonrenewable resources provide a powerful vehicle for capital formation. Economic depreciation in this situation, since it is calculated as the difference between present values of two stream of prospective yields, informs the decision of how much to produce today as opposed to how much to produce tomorrow. In short, economic depreciation in this case would determine the time path of depletion of the oilfield.
Chapter 10
Opportunity and Sunk Costs
In the preceding chapter, it was noted how the view that capital is stored (or embedded) labor can lead to problems in interpreting depreciation and whether or not depreciation is a component of long-run marginal cost. In this chapter, we shall look at some related questions involving opportunity costs and sunk costs, especially as they relate to costing and pricing issues in the regulated industries. The focus for the discussion will be questions raised by Richard Emmerson in a paper in a late-1990s volume on marginal cost techniques in the telephone industry sponsored by the National Regulatory Research Institute.1
10.1
Opportunity Costs
On p. 161 of the NRRI volume, the following statement is made: This nature of capital creates a “time problem,” resources are committed now, precluding their alternative uses (and thereby causing an opportunity cost), while at least some of the intended output is created later. A per unit calculation of “costs” requires a current cost to be divided by later quantities of output. Such arithmetic cannot be performed until either the costs are aligned with output or vice versa. By attending to proper time alignment, we account for the opportunity cost of the resources between the time of their commitment to production and the results of their production. Emmerson (1991, p. 161).
This statement, it seems to me, is symptomatic of a confusion that is widespread amongst economists, namely, that opportunity cost is somehow to be treated as an objective cost of an investment. The decision to invest is seen as causing a subsequent opportunity cost by precluding the resources from alternative uses. 1
I wish to thank Rick Emmerson for being such a good sport in letting me use statements from his NRRI paper as foils in this chapter. Rick has been an enthusiastic supporter of the ideas in this book for many years, and our many and long discussions have led to considerable improvement and refinement.
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However, this is an improper view of opportunity cost. Opportunity costs, which in general are subjective, are what drive choice and decisions.2 Once an investment decision is made, the stream of costs that the decision gives rise to are the objective costs of the decision. Once the investment is in place, the opportunity cost that drove the investment decision to begin with is no longer relevant.3 In addition, it is mistaken in my view to attempt to line up output at various points in time with the cost of the investment. Long-run marginal cost (which probably should be called long-run average incremental cost) is measured by the cost of the investment divided by some appropriate measure of the capacity of the plant represented in the investment. This could be either rated capacity, or rated capacity multiplied by some average “fill” factor. However, to attempt to identify components of the cost of the plant with specific units of output generated by the plant is nothing more than an arbitrary cost allocation.4 Closely related to the foregoing is the widely accepted view in the literature that those who cause a cost to be incurred should pay for that cost. This is a laudable sentiment, but this is all it is, a sentiment, especially in the context of pricing the output where highly durable physical capital is involved. Standard economic efficiency requires that price be equal to marginal cost, but the marginal cost in question is short-run marginal cost, not long-run marginal cost. For a good sold in a spot market, long-run marginal cost, as was discussed in Chap.5, informs investment decisions, but not pricing decisions. For operating rates short of full capacity utilization, the relevant guide to price is short-run avoidable cost. In this situation, it is clearly meaningful to say that those who cause costs to occur ought to pay those costs, but this is with respect to short-run operating costs, not capital costs. On the other hand, if capacity is fully utilized, price should be set at the point where output is allocated to those with the highest willingness-to-pay. In this case, the only thing that can be said about price in relation to cost is it will be above short-run avoidable cost. Again, there is no reference to long-run cost. So much for a good sold in a spot market. What about goods like telephone services and electricity, which have historically been sold under socially negotiated tariffs? As was noted in Chap.5, when output is sold under a long-term contract, it is perfectly reasonable and appropriate for capital costs to be represented in the 2
James Buchanan in his book, Cost and Choice (1969), provides convincing discussion of this point. See also Buchanan and Thirlby (1981). 3 Once an investment is made, the relevant opportunity cost for subsequent decisions involving that investment is the quasi-rents from the best alternative use to which the investment can be put. The opportunity cost which drove the investment is not the objective cost that has to be amortized out of the quasi-rents generated by the investment. The cost to be amortized is the price that was paid for the investment. 4 The motivation involved is a noble one, namely, to confront those adding to quantity demanded with the long-run costs of those decisions. The problem is that, except in the case where the demand decisions are embodied in long-term contracts, there is no meaningful objective way for this to be done. For output sold in a spot market, the relevant cost-guide for pricing is short-run avoidable cost, and this bears no necessary relationship at all to long-run marginal (or incremental cost).
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negotiated price. Indeed, if the time period of the contract should coincide with the payback horizon of the underlying plant producing the output, the floor to price should, in fact, be long-run marginal cost. However, this is the only circumstance in which it is plausible to identify cost causers (i.e., the demanders in the contract) with cost payers. The problem with trying to accomplish this for telephone and electricity rate payers in the circumstances of the real world are threefold: 1. With a mix of plants of different vintages, long-run marginal cost is inherently ambiguous, which means that any procedure to identify a single number as the long-run marginal cost will be arbitrary. 2. Tariffs are periodically, if not regularly, renegotiated, so that long-run marginal cost is, in effect, a moving target. 3. People and customers come and go, so that a customer whose current demands cause a capacity-augmenting investment today may not still be a customer when the new capacity comes on line. In my view, the problems discussed in this section can be attributed to an illusion, an illusion that it is meaningful to decompose the price of a good into the costs of its various production inputs, including capital. Capital costs drive investment decisions, but once an investment is made, the capital costs incurred become financial obligations that have to be covered out of the quasi-rents from the sale of current production. Whether or not the quasi-rents will, in fact, cover the capital costs will depend on short-run demand in relation to the short-run avoidable cost curve.5
10.2
The Measurement of Unit Incremental Cost
On p. 160 of his paper in the NRRI volume, Emmerson defines unit incremental cost (UIC) as the ratio of two differences in present value: UIC ¼
PV½Cðyt þ Dyt Þ PV½Cðyt Þ ; PV½yt þ Dyt PV½yt
(10.1)
5 The idea of identifying price in the long run with costs of production is, of course, a residual legacy of Classical economics. However, in the present context, the sentiment to make those who cause costs pay those costs is clearly helped along by the classic peak-load pricing papers of Steiner (1957) and Boiteux (1960). The conclusion of their papers is that peak demanders should pay all capital costs, while off-peak demanders should pay only operating costs. The Steiner and Boiteux papers are beautiful pieces of analysis, but they have in my opinion led to a lot of mischief because practitioners have tended to overlook the strong assumptions which yield the result. In general, what the Steiner–Boiteux analysis shows is that the peak price should be such as to allocate existing capacity output to those with the highest willingness-to-pay. The fact that this peak price equates to operating cost plus unit capital cost in the Steiner–Boiteux analysis is simply an artifact of the strong stationarity assumptions that are made: There is a single stationary technology, and demand is both stationary and known with certainty. None of these assumptions is even remotely close to being fulfilled in reality.
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where yt denotes output at time t and C(yt) denotes the cost of producing yt. My misgivings about the denominator have already been noted, so nothing further needs to be said about the discounting of output. The numerator defines the incremental cost of adding Dyt to output using the framework of Turvey (1968). That is, incremental cost is defined as the difference in the present values of two infinite-horizon cost streams, one for producing yt +Dyt and the second for producing yt. In my opinion, this is not the proper way of measuring the incremental cost of capacity. The cost of additional capacity should be defined simply as the objective cost of the capacity in question. This is then converted to a UIC by dividing by the amount of capacity involved. Moreover, Turvey’s procedure includes in the stream of costs of producing a particular output, the costs of periodic replacement of the underlying plant. A firm calculating the cost of a prospective investment does not, it seems to me, look beyond the expected useful life of the investment, for there is no need today to decide whether a decision to replace will be made tomorrow. That decision will be made when tomorrow comes. What the firm looks at in contemplating an investment today is whether (on an expected value basis, with allowances for risk) the quasi-rents generated by the investment will make the investment whole in relation to its cost. If the answer is yes, the investment will be undertaken (or capacity will be added to), and the cost of the increment of capacity is simply the objective cost of this capacity. As noted in footnote 4, the desire on the part of Emmerson and others is a noble one, namely, to confront those adding to quantity demanded with the long-run costs of those decisions. As just discussed, however, the problem is that, except in the case where the demand decisions are embodied in long-term contracts, there is no meaningful objective way for this to be done. The relevant cost-guide for pricing in a spot market is short-run avoidable cost, and this bears no necessary relationship to long-run marginal (or incremental) cost.
10.3
Sunk Costs
Later in the same paper in the NRRI volume, there is the statement: A cost is a sunk cost if, once committed, the cost cannot be avoided even by terminating business altogether. Equivalently, the cost of a resource is sunk if, once committed, to a specific purpose it [the resource] has no opportunity cost. Emmerson (1991, p. 186).
These are, I imagine, pretty standard statements (or definitions) of sunk cost. I do not have a problem with them as they stand, but I do not think that they clear up all of the confusion that surrounds the concept of sunk cost. To begin with, I think that the term sunk cost is unfortunate. To convey the idea intended, a much better term in my view would be sunk resources or sunk plant, for this is what is really involved – i.e., resources (or plant) that have a specific use and which cannot be transferred, on short notice, into another use.
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One must also distinguish between non-transferability of plant and non-transferability of the fluid capital that is embodied in the plant. Not being able to transfer physical capital to another use is something entirely different from not being able to transfer the capital embodied in the physical capital to another use. As was discussed in Chap.2 and again in Chap.5, the capital that is embodied in physical capital is transformed back into fluid capital through charges against quasi-rents. Plant that is completely sunk may nevertheless be perfectly fungible in terms of the capital that was embodied in it, because the capital has been entirely returned to the pool of fluid capital through myros recovery charges. The worst case scenario for “sunkness,” obviously, is when plant which has never generated any quasi-rents, with no prospects for ever doing so, has no alternative use. The Washington Public Power Supply System nuclear power generating plants in the state of Washington, which were started in the 1970s but never finished, provide a prime example.6 In another passage in the paper in the NRRI volume, it is stated that the current value of a perfectly fungible old plant with characteristics identical to those of new plant will be based on the cost of the new plant: Today, the running cost of the old plant is b [cf. Fig. 10.1]. Because the old plant is perfectly fungible, the old plant has an imputed capital cost equal to a. That is, were the old plant to be made available due to declining demand, the cost of new plant (d) could be avoided by incurring running cost (b) to reuse the old plant. The imputed capital cost of the old plant is the amount (a) and the total cost of the old plant is a+b(¼d). Thus, for perfectly fungible old plant (which is fungibly equivalent to new plant), a cost study which assumes all new plant is correct. Emmerson (1991, p. 188).
I have the following problems with this view of things: 1. To begin with, let us suppose that, at time t0, the old plant in question was being purchased from another firm. What would be the maximum price that the purchasing firm would be willing to pay? It is clear that the maximum would be given by the present value of the solid gray area in Fig. 10.1. If a capital value is to be imputed, it seems that it ought to be this number, rather than a. 2. However, it is not clear why there should be an imputation to begin with. If the purpose is to get the “capital” account of the firm right, I do not think this is the proper way to do it. When the plant was originally purchased, a certain price was paid for it, and this is the number that would be represented in the capital account of the firm’s books.
6
The standard view in economics concerning sunk costs is that they are bygones and are, therefore, irrelevant for current decisions. This may be true for sunk costs, but not for sunk plant. For the existence of plant that is used and useful can convey a powerful competitive advantage to the firm that owns it vis-a-vis firms that are contemplating producing from plant that would have to be constructed from scratch. This is because the total costs of production from new plant have to compete with only the avoidable costs of production from old plant. The capital costs of old plant, being sunk, do not figure into the floor to price for production from the old plant. This is why sunk plant can provide a barrier to entry.
Fig. 10.1 Investment in existing plant vs. a new plant
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Running Cost of Existing Plant Total (net) Cost of New Plant
d a
Running Cost of New Plant
b t0
t1
Time
Source: Emmerson (1991), p. 187.
3. Further to the preceding point: the “capital” embodied in the plant (as represented by the price that is paid for the plant) will be “recovered” – i.e., returned to the pool of fluid capital – through myros recovery charges against quasirents. If there is a failure of demand before the capital is fully recovered, but the plant is still usable and 100% fungible, then the capital cost of diverting the plant to a new use is what remains in the capital account of the original cost of the plant (plus, of course, any costs of conversion). 4. The essential point is that opportunity costs should not be capitalized. The discounted value of the shaded area in Fig. 10.1 is a genuine opportunity cost that drives the decision to reuse old plant rather than invest in new plant, but it is not a capital cost in the sense of embodied fluid capital that must be recovered from quasi-rents.
Chapter 11
Trade, Transfers, and Monetary Overhangs
In this chapter, we turn to questions involving international trade and the transfer of wealth from one country to another or from one region within a country to another. The focus, initially, will be on the emergence of trade between two previously closed monetary economies and the factors which influence the exchange rate established between their respective currencies. Following this, we will turn to transfer questions involving “monetary overhangs” and how they are related to the conservation laws imposed by the pool of fluid capital. Two examples will be considered, the first the “capital levy” proposed by Schumpeter for Austria at the end of WWI, the second the reunification of Germany in 1990 following collapse of the Berlin Wall.
11.1
Trade and Exchange Rates
In this section, we explore the factors that determine the exchange rate between currencies of two countries that engage in trade with one another. For convenience, assume that the two countries are Germany and the USA, so that the currencies in question are the deutschmark (DM) and the dollar.1 Assume, also, that these are the only countries in the world, and that they initially form two closed systems. Our procedure will be to trace out what happens when exchange between the two countries first emerges. As a point of departure, assume that Germany is in macroeconomic equilibrium and that the USA is as well, except for one individual who wishes to purchase a good produced in Germany. Payment for the good has to be in DM, so the individual must first find someone in Germany who is willing to give up DM in exchange for dollars. Assume that this is, in fact, accomplished and that the necessary DM are purchased at a rate of kDM per dollar. The German good is 1
Reference here, of course, is to Germany before the DM was replaced by the euro.
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purchased, makes its way to the USA, and is consumed. We want now to trace out what happens in the financial and goods markets in both countries as a result of these transactions. Let us begin with the USA, assume that the dollars used to purchase the DM are dollars that have been received as current income. Since these dollars are diverted to the purchase of a German good, it follows that a like value of US goods (valued in current prices) will not be sold, so (assuming that investment is not affected) there will be downward pressure on goods prices in the USA. Initially, there will be no effect on asset prices in the USA. Things will be more complicated in Germany. Let us assume, to start with, that the DM which are exchanged for dollars were being held as an asset. With the exchange, these DM are transformed into media of exchange, so there will be an increase in the volume of spending in Germany. Since the total stock of goods is fixed in the short run, the result will be upward pressure on goods prices in Germany. However, this is not the end of the story, for unlike in the USA, there will also be an effect on German interest rates and asset prices. Since it is assumed that the DM that are purchased are DM being held as an asset, and the fact (also by assumption) that Germany is in macroeconomic equilibrium, then the value for k must be high enough to overcome the liquidity preference of the marginal holder of DM. The resulting reduction in the amount of DM that are available to be held as an asset will put upward pressure on the money rate of interest and, through portfolio adjustments, on other interest rates as well (unless, of course, the German Bundesbank should take offsetting action). Assuming that the DM/dollar exchange rate k somehow gets determined, all of this seems straightforward. The important question, however, is how k is determined. To begin with, it has to be a truism that the German who gives up DM for dollars must see some benefits of holding dollars. What might these benefits be? There are three possibilities: 1. Interest rates are higher in the USA than in Germany, so that, while the German was a holder of money in Germany, he/she can be a holder of interest-bearing dollar-denominated assets. (This assumes, of course, that the German does not expect a sufficiently adverse movement in the exchange rate during the period of an investment in dollar-denominated assets so as to negate the interest rate differential.) 2. The German holder of dollars expects the exchange rate to appreciate sufficiently that a profit in DM will be made when the dollars are converted back into DM. 3. Although the German was a holder of money as an asset in Germany, he/she could decide to use the dollars to purchase US goods because US goods appear to be a bargain in relation to the price of German goods. Three determining variables for the exchange rate between two currencies emerge from this list: (1) interest rate differentials, (2) expectations of changes in the exchange rate, and (3) Purchasing-Power Parity differences between the relative purchasing powers (in terms of domestic vs. foreign goods) of the two currencies.
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The first two factors will primarily affect flows of financial capital between the countries, while the third factor – i.e., Purchasing Power Parity – will primarily affect trade flows. However, since a single exchange rate governs both types of flows, the exchange rate which emerges will be the result of all three factors.
11.2
Monetary Overhangs and Capital Levies
In a paper written in 1916, but not available to English readers until relatively recently, Schumpeter (1954), anticipating the monetary problem that would accompany the end of the ongoing great war in Europe, proposed a capital levy as the best method of dealing with these problems. The problem, as described by Schumpeter, was as follows:2 The first problem is fiscal. It is, in concrete terms, a matter of money: money which the state needs to fulfill its obligations and to get rid of its deficit. It is not a matter of goods, such as war materials, food and clothing for the army, etc. To be sure, the true costs of the war lie in the goods sphere: the used-up goods, the devastation of parts of the country, the loss of manpower, these are the real “cost” of war to the economies. It was the procurement of the mass of goods needed for the conduct of the war that was the great problem within which the raising of the necessary sums of money was a relatively subordinate problem of fiscal technique. However, this problem is already solved. What the armies and the peoples needed for warfare in the way of goods, we have raised already by hook or by crook and we shall continue to raise it during the war. The problem which then remains is merely a “question of money.” We shall be in the position of a businessman whose factory has burned down and who now faces the task of expressing this loss in his books. Like a huge conflagration the war has devoured a large part of our national wealth, the economy has become poorer. This has already happened, nothing can change it, and whatever goods were necessary for the purposes of war will have been supplied by the end of the war. However, in money terms, the economy has not become poorer. How is this possible? Simply so that claims on the state and money tokens have taken the place of stocks of goods in the private economies. The state cannot replace the goods it has taken out of the private economies – it could after all only take them from the economy itself. What is needed is simply an adjustment of money values which would return them to harmony with the world of goods, that is to say, a large-scale writing-down of book values. And this can be done only by the state covering its monetary obligations out of the money claims and money stocks of the economy. Schumpeter, The Crisis of the Tax State, in Swedberg (1991), pp. 118–119.
The problem described by Schumpeter is one in which, because of the destruction pursuant to war and the manner of its finance, the real value of national wealth is considerably smaller than the money value of the same. Since real wealth cannot be created en vacuo, the only way that the two values can be brought into “harmony” with one another is through a destruction of monetary 2 Schumpeter’s specific focus was Austria, but the problem he was concerned with is a very general one and, as we shall see in a moment, can be identified with the “monetary overhangs” that plagued the Eastern European economies in 1989 and 1990.
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claims, whether directly (as per a capital levy) or indirectly through inflation. As it turned out, the destruction in Austria occurred through a hyperinflation, following a failure on the part of Schumpeter, during the 6 months in 1919 that he was Finance Minister, to convince the Austrian government that a capital levy was the better route to take.3 The focus in the present section is not on Austria and Schumpeter per se, but rather on the modern day “monetary overhangs” that characterized the Eastern European economies in 1989 and 1990 on the eve of their transformations from centrally directed command economies into market economies. My purpose in this section is to draw parallels between the problems posed by these monetary overhangs and the problem addressed by Schumpeter, to discuss methods (other than inflation) of dealing with them, and to show that the solution taken in the reunification of Germany amounted, in essence, to a Schumpeterian capital levy. For purposes of discussion, a monetary overhang will be defined as a (positive) divergence between the stock of monetary claims on the pool of fluid capital and the goods represented in the pool valued in current prices. While there are a number of ways in which monetary overhangs can come into existence, the ones of present interest are the finance of war expenditures through the sale of debt and the accumulation of savings in an economy in which the only private asset is money. The former is what motivated Schumpeter’s analysis, while the latter will be assumed as a stylized fact characterizing the Eastern European economies during the years of communist rule. As ably described by Schumpeter, a monetary overhang emerges with war financed by debt because of the simple fact that the goods that the debt finances are for the most part destroyed, whereas the monetary claims continue to exist. The divergence in values between the claims and goods sides of the pool of fluid capital is both direct and unmistakable, and the only way that the divergence can be eliminated without an inflation in goods prices is through destruction of an appropriate amount of monetary claims. Schumpeter’s solution was through a levy on financial assets whose proceeds could be used only to retire debt.4 The monetary overhangs that characterized the Eastern European economies on the eve of their conversions to market economies had a much different origin than war debt, as the primary cause of these overhangs was an absence of assets other than money in which private savings could be held. To see what is involved, let us consider the polar case of an economy in which the only asset that can be privately owned is money. Income is received as money, and the claim
3
For a chronicle and detailed analysis of Schumpeter’s ill-fated attempt to effect the capital levy, see Stolper (1994, Chaps. 14–19). 4 The fact that the war debt in Austria was internal made a capital levy, in principle, feasible. The levy was to have been paid in either money or bonds. In the case of payment in bonds, the bonds would obviously have ceased to exist once they were received by the Treasury. In the case of payment in money, the money was to have been used to repay government loans from commercial banks as well as the central bank.
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tickets it represents can either be exercised in the purchase of consumer goods or saved.5 If saved, the unexercised claim tickets can be held either as cash or as deposits in a bank. Real assets are owned by the state, so that there are no equities or bonds. Houses are not owned, but are rented (or provided free) by the state, so that there are no mortgages. There are no precious metals, “Old Masters,” or other stores of value. In short, it is either money or nothing.6 In this situation, the pool of fluid capital is co-extensive (on the claims side) with the stock of money held as an asset. On the goods side, things are more complicated, for most (if not all) of the goods left “unclaimed” by saving are ultimately consumed as investment in produced means of production (i.e., physical capital), whose ownership resides with the state. The result is the creation of a monetary overhang, though of a different type than that created by war debt. What monetary overhang means in these circumstances is that, compared with a “normal” economy in which there are private property rights and many forms of assets (both real and financial) in which savings can be held, there is too much latent liquidity. This latent excess liquidity would become manifest if an economy with such an overhang were suddenly to be merged with a normal economy at a currency conversion which left the overhang intact. The economy of East Germany at the time of its integration into West Germany in 1990 provides a precise case in point, and it is to this that we will now turn. However, in order to establish the central ideas, it will be useful initially to consider the transfer problems involved in terms of two stylized economies.
11.3
Wealth Transfers and Monetary Overhangs: A Stylized Analysis
In the present section, we shall lay the groundwork for analyzing the purely economic problems of integrating the two German economies, using the macroeconomic framework which has been developed in this book. Social and cultural problems associated with the integration will not be addressed except in passing. The procedure in this section will be to set up two stylized economies, one with high levels of income and productivity and the other with low levels of the same. Complete integration of the two economies will then be analyzed, taking into the account the conservation laws imposed by the pool of fluid capital. 5 This is an obvious stylization of how income was received in the communist command economies, for much of income was received in kind in the form of nonmarket prices for housing, food, public transportation, and free medical care, etc. 6 In East Germany, homes could be owned, as could small craft-type businesses, and there were small amounts of privately owned life insurances policies in force at the time of the monetary union with West Germany. Also, states cannot completely eliminate the values placed on privately created works of art, etc. Yet the fact remains that, at the time of the monetary union, the bulk of private Eastern savings was held as money.
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Let the two economies being merged be denoted by D1 and D2, respectively, each with the following characteristics at the time of merger: 1. D1 has high levels of income and productivity, while D2 has low levels of the same. 2. The population of D1 is four times that of D2, 64 million in D1 and 16 million in D2. 3. Produced means of production are privately owned in D1, but owned by the state in D2. 4. The economy in D2 is command, while the economy in D1 is market-driven. The newly integrated economy will be market-driven and its social welfare system will be that of D1. 5. Although the currencies in D1 and D2 share the same name (mark), assume that the “market” exchange rate for D2 goods exported to D1 is four D2 marks for each D1 mark. 6. Assume that the value of the pool of fluid capital in D1 is 250 billion D1 marks, while the value of the pool of fluid capital in D2 is 28 billion D2 marks. 7. Assume that residents of D1 hold 200 billion D1 marks as an asset and that residents of D2 hold 48 billion D2 marks. The terms of the merger are assumed to specify that, within the borders of the “new” country (D), all restrictions on the movement of goods, human resources, and capital (whether fluid or otherwise) are eliminated immediately and completely. Secondly, it is assumed that the D2 mark is placed at parity with the D1 mark. Finally, it is assumed that the two economies are closed in terms of capital movements. With these assumptions, we now turn to an analysis of some of the macroeconomic consequences of the merger of the two economies, specifically as regards: 1. 2. 3. 4. 5. 6. 7.
The immediate effects on the residents of D1 The immediate effects on the residents of D2 The longer-run effects on investment The longer-run effects on the pool of fluid capital The longer-run effects on the growth of income The consequences for inflation The period of time that might reasonably be expected for full integration of the two economies to occur
At the point in time that the exchange rate between the two currencies was pegged at par, there would be a transfer of wealth from holders of D1 marks to holders of D2 marks. This would not have been the case had the exchange rate been established at the “market” exchange rate for goods of four D2 marks for each D1 mark. This conclusion is a straightforward consequence of the conservation laws imposed by the pool of fluid capital. Specifically, at the time of the currency merger, the stock of fluid capital in the two economies was (per our assumptions) equal to 257 billion marks evaluated in D1 marks (using the assumed “market” exchange rate of four to one). The amount of money held as an asset in the two economies is
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248 billion marks in total, but only 212 billion evaluated in D1 marks. Pegging of the two currencies at par accordingly accords the holders of D2 marks the equivalent of a windfall of 36 billion D1 marks. Because the real value of the pool of fluid capital for the two economies is set by the market exchange rate of the two currencies, it is invariant to the pegged exchange rate. Since the number of D1 marks held by D1 residents does not change, but (with the pegging at par) the number of D1 marks held by residents of D2 is in essence increased by 36 billion, the number of “new” marks held by residents of D2 is increased relative to the number held by the residents of D1. Since the aggregate amount of wealth in the two economies is constrained by the real value of the combined pools of fluid capital, and because this is invariant to the pegged exchange rate, there is necessarily a transfer of real wealth from the residents of D1 to the residents of D2. The foregoing conclusion is a purely formal consequence of the invariance of the real value of the pool of fluid capital. As such, it does not say anything about how the transfer of wealth might actually be effected. Since pegging of the exchange rate between the two currencies at par rather than at the market rate of four to one amounts, in effect, to an autonomous increase in the stock of money held as an asset of 36 billion marks, and since there is no offsetting increase in the capacity of the “new” economy to produce, the transfer necessarily has to take place through inflation in some form or another.7 There are several mechanisms by which this could occur, and I will single out two for discussion: inflation in the goods market and inflation in the asset market. The most obvious and direct way for the transfer of wealth to occur would be through price inflation in the goods market, as residents of D2 (who now have free movement into D1) spend at least part of their windfall of 36 billion marks on goods produced in D1. The result would be a once-and-for-all increase in the general price level.8 A transfer through asset inflation, on the other hand, is more indirect. Assume that residents of D2 decide to hold part of their 36 billion-mark windfall as an asset, though not necessarily in the form of money. Since equities in produced means of production could not be owned in D2, but could in D1, residents of D2 held a larger proportion of their wealth in the form of money than did residents of 7
I am assuming at this point that there are no assets to be held in D2 except for money and goods. A different conclusion could emerge if, at the time of the currency merger, D2 residents were also to acquire property rights in D2’s produced means of production. This will be discussed below. 8 Since goods produced in D2 would almost certainly be less desirable than goods produced in D1, it might seem that inflation could be contained by price decreases for D2 goods. This would not be the case, however, so long as the windfall to D2 residents leads to a net increase for the newly combined economies in the desire to consume, for a now larger pool of purchasing power is coming up against the same amount of goods. Prices of D2 goods may very well decrease, but any decreases will necessarily be more than offset by price increases in D1. Also, it should be noted that it is implicitly being assumed that the economy of D1 is operating at full capacity. If this should not be the case, then some of the increased demand for D1 goods could be accommodated by an increase in utilization with little or no inflation. I am grateful to Dieter Elixmann for pointing this out.
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D1. Since with merger (but before privatization of D2’s produced means of production) D2 residents can now purchase D1 equities, it would be reasonable for them to do so, not only out of their windfall of 36 billion marks, but out of their equivalent “original” holdings of 12 billion D1 marks as well. The result will be an increase in the price of D1 equities. Since the D1 equities purchased by residents of D2 were held by residents of D1, the mark balances of the latter will be increased. If all or part of these increased balances is spent on goods, then goods prices will also increase, and there will once again be a transfer of wealth through inflation. On the other hand, if the residents of D1 choose to hold their increased mark balances as an asset, goods prices will not be immediately affected, and it might seem that there has been no transfer of wealth. This is not the case, however. Because the real value of the stock of money is always constrained by the pool of fluid capital evaluated in current prices, the fact that the stock of money has increased, whereas the general price level has not, simply means that the inflation is latent. Holders of the increased mark balances may individually feel that their wealth has not changed, but as a group their wealth has necessarily been reduced. This will be manifested by the latent inflation becoming open inflation whenever there is an attempt to convert the increased mark balances into goods. Until this occurs, the holders of these increased mark balances (again as a group) will live under an illusion that their real wealth is the same as it was before the merger. For the illustrative numbers which are being used, pegging the exchange rate at par effectively transfers 36 billion D1 marks of wealth from residents of D1 to residents of D2. Since the total wealth of D1 prior to the merger was 250 billion D1 marks (the value in current prices of the pool of fluid capital in D1), a transfer of 36 billion marks is equivalent to a capital levy on D1’s residents of about 14%. Pegging the exchange rate at par also has implications for the real purchasing power of current income. Prior to the merger, each mark of income in D2 was the equivalent of one-fourth of a mark of income in D1, whereas after the merger the two marks are at par in purchasing power.9 By assumption, real income per capita is much higher in D1 than in D2, but the disparity was much larger prior to the merger than after. Prior to the merger, per capita income in D2 was only 11% of that in D1, whereas after the merger it is 43%.10 Since, initially anyway, there will be no increase in the amount of goods available, the increased real purchasing power of the D2 residents, occasioned by the pegging of the two currencies at par, will lead to an inflation in goods prices, thereby causing a reduction in the real purchasing
9 This is with respect to the consumption by D2 residents of D1 goods, and accordingly does not take into account the much lower prices of non-traded goods in D2. In terms of purchasing-power parity, therefore, the “market” exchange rate will understate the real purchasing power of the premerger D2 mark. The implications of this will be discussed below. 10 Although illustrative numbers for total income in the two economies have not been provided, total income will always be of the same order of magnitude as the value of the pool of fluid capital. The numbers in the text are accordingly derived using 250 and 28 billion as the total incomes for the two economies in conjunction with the populations of 64 and 16 million.
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power of incomes in D1. In terms of the numbers we have been using, goods valued in pre-merger prices of 257 billion marks will be confronted by a pool of postmerger purchasing power of 278 billion marks, which implies an increase in the general price level of 8.2% and a reduction in the real purchasing power of D1 incomes of 7.6%.11 The conclusion from this analysis is clear. The decision to peg the two currencies at par results in substantial transfers of both wealth and real purchasing power of income from the residents of D1 to the residents of D2. The enabling mechanism in both cases is inflation. In view of this, let us now ask what would happen if the monetary authority were to seek to contain the inflation. In particular, let us suppose that the central bank attempts to kill the inflationary potential caused by the pegging of the two currencies at par through a 32 billion-mark reduction in the total stock of money. This could, in principle, be accomplished within one period of production by forcing the banking system (by whatever means) not to renew 32 billion marks of existing loans. Since most loans represent working capital for financing current production, the result would almost certainly be a major recession. Inflation might be contained, but at a cost of substantial unemployment and loss of income. In fact, with fewer goods available as a consequence of the reduced availability of working capital, the most likely outcome would be both inflation and unemployment! While the transfers of wealth and real purchasing power caused by pegging the currencies of D1 and D2 at par at the time of merger is one thing, the effects of these transfers on the morale of the people involved is something else. The residents of D2, being the recipients of substantial windfalls, would almost certainly be elated. But this will not be the case for the residents of D1, for they are on receiving ends of substantial capital and income levies, which for the most part are hidden since these levies take the form of an inflation tax. While increases in real income and wealth can boost morale, decreases never do. The analysis to this point has dealt entirely with the wealth and real income transfers implied by the conservation laws imposed by the pool of fluid capital as a consequence of conversion of the two currencies at par. We now turn to questions involving the longer-term effects of the integration of the two economies on levels of investment, productivity, and income. The effects in all three instances depend upon what happens to the size of the pool of fluid capital. Before going into details, however, several points concerning transitory economic forces which would come into play at the time of integration need to be discussed. The first point concerns the elimination of all restrictions on the movement of labor. Since the pre-merger real wage in D2 is substantially below that in D1, lifting the restrictions on the movement of labor will obviously encourage labor to migrate from D2 to D1. On the other hand, pegging the two marks at par clearly counteracts 11 This 8.2% inflation in goods prices is in addition to that triggered by the increase in real value of the D2 marks held as an asset which is caused by the pegging of the two currencies at par. The analysis assumes that D2 goods continue to be desirable at pre-merger prices. If this were not so, then the inflation in D1 goods would be greater than 8.2%, in which case the decrease in real incomes in D1 would be even larger.
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these forces, for (as already noted) conversion at par increases the D2 real wage (in terms of D1 prices) from about 10% of the D1 pre-merger level to about 40% postmerger. Taking non-traded goods into account (assuming that their nominal prices remain at pre-merger levels) moves the D2 real wage even closer to the D1 level. Conversion at par accordingly might foreclose labor migration altogether. A second point concerns the produced means of production in the dowry of D2, for it is highly unlikely that these will have all that much to contribute to the overall productive capacity of the newly combined economies. Two factors are at issue. The first relates to the general desirability of the goods produced in D2, while the second relates to the strong likelihood that, desirability aside, much of D2’s produced means of production is economically obsolete. Since D2 was a command economy, both the quality and the range of goods that D2’s productive structure is capable of producing will not likely be in accord with choice-driven market demands.12 The upshot is a serious mismatch, at least in the short run, between goods that will be demanded in the newly integrated economy and the goods which D2’s produced means of production are capable of supplying. But even if such a mismatch were not a problem, it would be likely in the circumstances that D2’s productive capacity is so technologically obsolete that, with the higher real wage rates induced by the decisions to peg the two currencies at par, much of the capacity is economically obsolete as well. Because of these factors, much of the productive capacity in place in D2 at the time of merger will be of little or no value as it stands, and the capital which remains sunk in it will be unrecoverable – unrecoverable in the sense that there will be no revenues against which myros recovery charges can be taken which would transform the capital remaining in this productive capacity back into the pool of fluid capital. Among other things, an implication of all this is that the goods inflation caused by pegging of the two currencies at par will be exacerbated because of a decreased supply of goods (in relation to the apparent productive capacity of the combined economies). Obviously, a major goal of integration is to bring the levels of income and productivity in the two economies into parity, where parity is presumed to mean increasing income levels in D2 to the levels of D1, rather than vice versa. We have seen, however, that one of the immediate effects of the merger is to reduce the level of real income in D1 by a transfer of wealth from residents of D1 to those of D2. In the long run, income parity will obviously require, if morale is to be maintained, that real incomes in D2 increase more rapidly than real incomes in D1.13
12 Moreover, for the real-world circumstances in question, this problem is compounded by the fact that D2’s productive structure was highly geared to external markets which, for the most part, ceased to exist. 13 Reference here is to people rather than to geography. Presumably, what is meant by parity in the long run is that the distribution of real income reflects ability rather than former place of residence in D1 or D2.
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Purely in terms of economics, the crucial consideration in the longer run concerns what happens to investment, and even more fundamentally, what happens to the pool of fluid capital. Clearly, for D2 incomes to be brought up to the levels of D1, investment not only has to take place, but in amounts well in excess of past levels. In a closed system, the only way the capital can be created to fund this investment is through a higher saving rate. However, this may be difficult because of the two circumstances: the transfer of wealth from D1 to D2 caused by pegging the two currencies at par, and extension to the residents of D2 the same welfare benefits as enjoyed by the residents of D1. Both clearly encourage consumption. The problem could be circumvented by tapping into the global pool of fluid capital, but this would require either loans from abroad, or an assessment on the part of foreign private capital holders that D is an attractive place to invest. A major factor driving investment in the “new” D ought to be investment in new manufacturing facilities in D2 as production, at least on the margin, is shifted to D2 in consequence of prospectively lower labor costs. However, I say “ought to be” rather than “will be” because labor costs may not be lower in D2 than in D1. Three factors could contribute to this not occurring: (1) inflation in D2 wage levels which moves them toward parity in nominal terms with wage levels in D1, (2) inadequate infrastructure in D2 (especially transport and communications), and (3) ceteris paribus, D2 workers may simply not be as productive as D1 workers. If investment in D2 is not stimulated by the prospect of lower production costs in D2, then the only static factor spurring investment in D (viewing D as a closed system) would be the incentive of producing for a now larger domestic market. It is unlikely, however, that the investment forthcoming for this reason alone would be sufficient, over any reasonable period of time, to narrow the income gap in a socially acceptable manner. To fund in a non-inflationary way the investment that would be needed to achieve this would require either a substantial increase in the domestic saving rate, or healthy inflows of capital from abroad. Neither of these would seem to be probable, primarily as a consequence of a likely absence of optimism. Optimism is necessary because investment is governed by prospective yields, and if much of the population is pessimistic about the future, the “animal spirits” of those making investment decisions will almost certainly be dampened. But why should pessimism be the norm, rather than optimism? After all, 20% of the population of the new D now face much improved economic prospects (and presumably much better social and political prospects as well). The problem, obviously, lies with the other 80% of the population who experience the decrease in real income occasioned by the pegging of the two currencies at par. Not only are there no immediate prospects of this decrease in real income being made up, but the malaise is heightened by almost certain action (given the real-world historical circumstances) by the central bank to raise interest rates in an effort to curb the attendant inflation. As been pointed out, however, some amount of once-and-forall inflation is inevitable as the general price level adjusts to the exogenous increase in the stock of money held as an asset caused by the currency conversion at par. The primary effect of higher interest rates will consequently be a further erosion of real income of D1 residents as the economy slides further into recession.
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Policies for Eliminating a Monetary Overhang: The Case of German Reunification
With the foregoing as background, let us now turn to the reunification of the two German economies as this actually unfolded. The monetary integration of the two German economies took place on July 2, 1990, at which time all East German ostmarks were converted into deutschmarks according to the following schedule: 1. The number of marks that could be exchanged at a rate of 1:1 was limited to 2,000 for children under the age of 15, to 4,000 for adults under the age of 60, and to 6,000 for people over 59. 2. Most of the rest of the money stock was converted at a rate of 2:1, except for money acquired for speculation in the year of unification, which could only be exchanged at a rate of 3:1. 3. Financial claims and debts [mainly firm’s debts (260 billion ostmarks) and housing loans (108 billion)] were converted at a rate of 2:1. 4. The rate for price and wage contracts and pensions was 1:1. Pensions were to be based on East German wages, but calculated according to West German formulae. The motivations (both political and economic) for monetary conversion on these terms were primarily threefold: (1) to ensure the population that unification would proceed, (2) to make it clear to East Germans that there were no longer economic reasons for them to migrate to the West,14 and (3) to provide the East Germans with a fair amount of financial capital for their entry into a united Germany. As was noted, there was a monetary overhang in the GDR that was the consequence of severely restricted private property rights and the resulting absence of financial instruments of wealth other than money. The average conversion rate of the stock of money of about 1.8:1 was designed to remove this overhang and to provide the newly combined German economies with a proper amount of liquidity.15 In terms of the analysis in the preceding section, the monetary overhang
14
As discussed at length by Sinn and Sinn (1992, Chap. 5), the conversion of price and wage contracts at par was actually a two-edged sword. For although (per the earlier discussion) it raised the real wage in the East relative to the West, it also increased the wage costs of Eastern production to the point where a rapid inflation of nominal Eastern wages toward parity with nominal Western wages would make Eastern manufactures unsalable. In the event, this is what occurred, resulting in massive Eastern unemployment. 15 The point of reference (as determined by the Deutsche Bundesbank) for the “proper” amount of liquidity was the ratio of M3 to GDP which prevailed in the FRG at the time of monetary union. The appropriate conversion rate accordingly became extremely sensitive to the assumption that was to be made concerning potential output in the GDR as a proportion of potential output in the FRG. In the event, it was assumed that GDR potential output was 9.5% of FRG potential output. The conversion rates chosen implied a resulting increase in the M3 money stock of 12% and a remaining monetary overhang for the combined economies of about 5%. For a detailed discussion, see Hasse (1993). Cf., also, Sinn and Sinn (1992, Chap. 3).
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represents the potential transfer of wealth from West to East that was discussed in connection with conversion of the two currencies at par. The decision to exchange ostmarks for deutschmarks at an average rate of about 1.8:1, rather than at 1:1, nullified a substantial part of the transfer and forestalled much of the inflation that such a transfer would have invoked. On the other hand, while the conversion may have been successful at one level, Sinn and Sinn (1992) argue that there was also a dark side to the process, in that conversion at less than par unfairly eliminated a substantial part of private Eastern wealth. The argument turns on the severely restricted private property rights which prevailed in the GDR, and the ownerless produced means of production that came into being with the dissolution of the communist state. As was noted earlier, the fact that there were no equities and bonds for Eastern residents to own meant that private savings in the GDR had to be held mostly in the form of currency and bank deposits. This would lead to a monetary overhang, but only in the sense that money holdings are out of equilibrium from what they would be if other forms of real and financial assets were also available. One of the points made by Sinn and Sinn – and it is an important one – is that much, if not all, of the monetary overhang could have been neutralized without destruction of the claims it represented on the pool of fluid capital by allowing Eastern residents to give up money in exchange for equity in the East’s produced means of production. Sinn and Sinn argue that, in these circumstances, all of the East German money stock could have been converted into deutschmarks at par, without great danger of inflation.16 However, this would have required a much different process of privatization of East German industry than what, in fact, was followed. The privatization process set in motion was for the property rights to East German industry to be transferred from the state at large to a state trust (the Treuhandanstalt, or simply the Treuhand), which then had the responsibility of transferring title into private hands either through restitution to previous owners or through sale. Rather than going into the multitude of problems that this process of privatization created,17 I want, instead, to consider the implications for noninflationary conversion if holders of ostmarks had been allowed to exchange ostmarks for marketable fractional ownerships in the East German produced means of production. For concreteness in the discussion to follow, let us suppose that the marketable fractional ownerships in question had come into being through an initial transfer and auction process as follows:18
16 Sinn and Sinn cite evidence that the two marks were essentially at par in terms of purchasingpower parity and therefore that par was the proper conversion rate. See Sinn and Sinn (1992, especially Chap. 3). 17 See Sinn and Sinn (1992, Chap. 4). 18 The actual details of the initial transfer and auction of ownership rights are not key to present purposes. What is important is that property rights in the East’s produced means of production become available to holders of ostmarks so that some form of portfolio adjustment could occur.
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1. Up to 50% ownership in each East German enterprise is put up for auction for sale to the public with payment in ostmarks. 2. The remaining 50% ownership is retained by the Treuhand. 3. The Treuhand is organized as an investment trust. Ownership of the Treuhand is transferred to the public by granting each member of the East German population one marketable ownership share of the trust. 4. Once the initial auction and transfer of shares in the Treuhand is accomplished, trading of shares, both of businesses and of the Treuhand, including the business shares retained by the Treuhand, can be traded for any currency whatever. It is critical that steps (1–3) have been strictly internal to residents of the GDR, for the purpose of these steps would have been to create property rights in the East’s produced means of production and then to transfer these property rights, part directly and part by auction, to the East German public. The auction part of the transfer would have allowed holders of ostmarks, whose savings allowed construction of much of the physical capital stock to begin with, to include equities as well as money in their portfolios of assets. In principle, such portfolio adjustments would have extinguished most, if not all, of the monetary overhang. Equally importantly, the transfer process would also have eliminated the capital overhang characteristic of communist command economies in which the real value of the stock of physical capital exceeds the value of the marketable financial assets.19 Let me now turn to the question of whether the monetary overhang would, in fact, have been eliminated by the privatization process just described. If holders of ostmarks did not see value in the produced means of production that were offered at auction, then at least part of the monetary overhang would have remained.20 Because Eastern assets were not purchased when they were available does not mean that Western assets (including goods) would not have been purchased when they became available. In this situation, conversion of ostmarks into deutschmarks at par would almost certainly have resulted in some inflation in either West German goods or West German assets (or both). To completely extinguish the monetary overhang in these circumstances would, indeed, have required conversion of ostmarks into deutschmarks at something less than par.21 19
See Sinn and Sinn (1992, p. 66). I am assuming in all of this that sufficient market mentality would have existed for the East German population to meaningfully participate in the auctions of ownership shares. Obviously, this may not have been a valid assumption. 20 What is at issue here is whether the real value of the stock of produced means of production, as measured by the prospective yields of these assets from the sale of marketable goods and services, is less than the nominal stock of savings, as represented in the holdings of ostmarks. There are many ways in which this might come about, including capital consumption and a production structure that is poorly adapted to produce the goods that will be demanded through the free exercise of tastes and preferences. The end result, in one form or another, has to be a reduction in the stock of ostmarks, so that the real stock of money is in accord with the stock of fluid capital. 21 It is assumed that the ostmarks received by the Treuhand from the initial auction of ownership rights would have been neutralized, so that the monetary overhang was not simply transferred from individuals to the Treuhand. As will be discussed in a moment, the best form of neutralization would have been transfer of the ostmarks to a bank for “reconstruction and development.”
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In the situation just described, destruction of a monetary overhang remaining after the transfer of property rights to the East’s physical capital stock by conversion at less than par would not have been unfair to the holders of the overhang, because the real capital which the overhang initially allowed to be constructed no longer existed. One way or another, the overhang would have been destructed, if not by conversion at less than par, then by inflation. Such is a necessary consequence of the conservation laws imposed by the pool of fluid capital. Smooth and timely integration of the East German economy into the West required that investment to transform the production structure of Eastern industry begin immediately. Two types of investment were needed. The first type is investment that is simply to increase productive efficiency. In some cases, this can be achieved by “Obstacle Removal,”22 while in other cases existing plant may have been so obsolete that it had to be scrapped altogether and new productive facilities created from scratch. The second type of required investment relates to a restructuring of production capacity that would have enabled the goods and services demanded by the free exercise of preferences to be produced, not only for the new domestic economy, but for export markets as well. If privatization had proceeded according to the scenario just outlined, finance of investment in the East could have been provided, at least in part, by the money that passed to the Treuhand in the initial auction of ownership shares of Eastern industry.23 To the extent that this occurred, finance of Eastern investment would have been provided by Eastern savings themselves, although most of the goods (except for labor) almost certainly would have had to have been purchased from the West or from abroad. However, the foregoing is not how privatization actually proceeded, and it is now clear (with hindsight) that the process which was chosen has positively hindered the transformation of Eastern industry. To begin with, effective destruction of much of the monetary overhang at the start by conversion of ostmarks into deutschmarks at less than par foreclosed any opportunity for the savings represented in the overhang to be mobilized as a source of investment finance.24 Secondly, about the only thing that has been accomplished by the privatization policy followed by the Treuhand was to create uncertainty and delay. By choosing, 22 “Obstacle Removal” (from the Obstacle Removal Law) represents investment in retrofitting and upgrading of existing plant. There is a neat French word, bricolage – “a cobbling together of contraptions from whatever is available” – which is even more expressive. [The descriptive phrase is Patricia Churchland’s, as quoted in Lewin (1992, p. 164).] 23 There are several ways that the money thus collected could have been made available for financing investment. Two obvious ones are that the funds could have been transferred to a newly created bank for “reconstruction and development,” or the Treuhand itself could have functioned as a financial intermediary. 24 It is to be emphasized that removing the monetary overhang by conversion at less than par caused no destruction of the pool of fluid capital, but only the claims on the pool that these ostmarks represented. The claims that were destroyed were transferred to those who were subsequently able to purchase ownership shares in East German businesses at prices lower than would have been the case if all ostmarks had been converted at par.
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wherever possible, to restore property rights to original owners, rather than simply compensating these owners for their losses, the whole matter of property-rights transfer was considerably delayed because of problems of determining who original owners were. Even worse than the delay that this entailed was the creation of uncertainty sufficient to forestall sale of large numbers of businesses from the Treuhand inventory. Contributing to the delay in transformation of Eastern industry, moreover, was the rapid increase in nominal wages in the East, the reasons for and implications of which are well-documented in Chap. 5 of Sinn and Sinn (1992). Although the ostmark may have been at par with the deutschmark in purchasing-power parity at the time of the monetary union, its “market” exchange rate in terms of traded goods was more of the order of 4:1. In the circumstances, competitiveness of Eastern goods required that Eastern wages rise no faster in relation to Western wages than the rate at which Eastern productivity increased toward parity with the West. Eastern money wages rising faster than the rate at which the productivity gap was closed obviously meant that Eastern traded goods became unsalable, and the only possible result was the massive unemployment that in fact occurred.
11.5
The German Reunification: An Assessment25
The primary purpose of the last two sections has been to analyze (using the conservation laws imposed by the pool of fluid capital) the transfer problems posed by the reunification of Germany following the fall of the Berlin Wall. The principal conclusions of the earlier theoretical analysis were that, because of the monetary overhang in the East, conversion of the two currencies at par would have implied a wealth transfer from West to East that would have led to inflation in both goods and asset prices, higher interest rates, reduced morale in the West, depression in the East, and most probably a recession in the West. In the event, only part of these conclusions has been borne out. By removing much, if not all, of the monetary overhang by converting ostmarks into deutschmarks at a rate of about 1.8:1, rather than at 1:1, the wealth transfer from West to East was largely averted. However, as is pointed out by Sinn and Sinn (1992), and analyzed at length above, much of the same outcome almost certainly could have been obtained by a privatization process which allowed for the accumulated savings represented in the monetary overhang to be exchanged for ownership shares in the East’s produced means of production. To the extent that such ownership shares commanded value, four things would have been accomplished: (1) property rights to the East’s productive capacity would have been established and 25
I do not mean to imply that Eastern savings would have been sufficient to finance all of the investment that was needed in the East. Obviously, this would have been far from the case. Nevertheless, Eastern savings could have made an important contribution and would have relieved some of the pressure on Western savings.
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transferred; (2) the monetary overhang would have been removed without its destruction; (3) holders of ostmarks would not have been deprived of a good part of their savings; (4) the stage would have been set, through the establishment of a “reconstruction and development” bank in one form or another, for Eastern savings to be mobilized for the finance of new investment.26 Primarily because of the rapid rise of Eastern wages in relation to wages in the West, Eastern traded goods lost whatever cost advantage that they may have had, and the result was a depression with cosmic levels of unemployment. Moreover, the depression in the East was greatly exacerbated by the failure of an investment boom to materialize, in great part because of the delays and uncertainties created by the processes of privatization followed by the Treuhand. All considered, however, the capital market in the West appears to have worked exceptionally well. As expected, interest rates increased, imports rose sharply relative to exports, and Germany turned from being capital-exporting to capitalimporting.27 Because of substantial income transfers from West to East, spending in the East was maintained despite the massive unemployment. Moreover, because of the rapid rise in Eastern wages coupled with unemployment benefits calculated according to Western formulae, the East’s unemployed have largely remained at home, so that unemployment in the East has not been exported in a major way to the West.
26
It is not clear, however, how much of the turn in the capital account reflects (1) purely shortterm financial capital movements because of the relatively higher German interest rates; (2) the finance of imported goods and services; or (3) real investment in German industry (whether in the East or the West is immaterial). (1) and (3) would be consistent with a higher exchange rate, but not (2). The higher exchange rate of the DM with the dollar in the early 1990s was, in my opinion, a consequence of US domestic and international policies. 27 For an assessment (as of September 2005) of the results of reconstruction of the former East Germany, see http://www.spiegel.de/international. The key results in terms of the present discussion are that, despite the construction of a number of state-of-the-art factories, the East remains economically stagnant. Unemployment is very high, and subsidies of the order of 100 billion euros per year from the West are needed for survival.
Chapter 12
Questions Related to Consumption and Saving
As we have seen, decisions to save out of current income are additions to the pool of fluid capital, while decisions to consume or invest in produced means of production are subtractions. The economic drivers in an economy have been seen as owners/ operators of productive capacity deciding how much of that capacity to utilize, entrepreneurs deciding how much to invest in new capacity, and households deciding how much of their income to consume. In general, this book has not been about the motivations that cause these decisions to occur, but rather about the implications of the decisions for changes in the pool of fluid capital and attendant effects upon interest rates and the general price level. The purpose of this chapter is to take a more detailed look at questions relating to consumption and saving and how these, in turn, relate to the constraints imposed by the pool of fluid capital. Under the assumption that individuals save because they wish to transfer purchasing power from the present to sometime in the future, not only do decisions to save have implications for the current level of economic activity and the capacity of the economy to grow, but so too do the decisions to consume accumulated savings when the appropriate time arrives. The really interesting questions in this regard concern the implications for the overall economy of retirement-motivated saving and retirement consumption. In the first section of this chapter, these implications will be explored under the standard life-cycle assumption that all saving either by or for the benefit of individuals is for financing retirement consumption.
12.1
The Macroeconomics of Retirement Saving and Consumption
Saving for retirement can take two avenues, private and social. With private saving, individuals are responsible for providing for their retirement consumption, while with social saving, the public sector has the responsibility. Private saving is
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voluntary, social saving is not. With social saving, saving takes the form of taxes collected by the government, while the benefits which are paid out upon retirement are usually determined according to formula. Social Security in the United States provides an obvious example of a socially based saving system.1 To begin with, let us assume that an individual who saves for retirement is able to obtain, over the period that the savings are held, a return which is in excess of the natural rate of interest. Obviously, this can be done for any individual, but it cannot be done for everyone, for in general the value of the claims on the pool of fluid capital cannot increase faster than the natural rate of interest. When individuals who have been saving for retirement finally retire and begin to consume out of their savings, the goods consumed have to be drawn from current production, as the goods which went into the pool of fluid capital at the time of initial saving will, in general, have disappeared. In short, current consumption, no matter what its source, must always be drawn from current production. Consider now the case of a social saving system. Since the system is universal, it follows that the stock of claims associated with it cannot grow faster than the natural rate of interest. Among other things, this means that if the current recipients of social retirement payments are (as a group) receiving a total amount which (assuming no inflation) is greater than the natural rate of interest applied to the recipients’ contribution (appropriately compounded), then they are drawing more than their “share” from current production. Those in retirement obviously consume in excess of their current income, so that the goods that they consume, if the pool of fluid capital is not to be reduced, must be financed out of positive saving elsewhere in the economy.2 Thus, to the extent that the amount spent on consumption by current recipients of social retirement payments is in excess of the contributions of the same, appropriately compounded by the natural rate of interest, there is a transfer from the presently employed to the retired. An important difference between private and social saving is that, with social saving, there is no direct connection between the amount saved (i.e., the taxes paid) and subsequent retirement payments received. The latter are politically determined and bear no necessary relationship to the amount paid in taxes. With private saving this is not the case, for there are well-defined claim tickets associated with the savings, which must be reconverted to money when the savings are to be consumed. There is, accordingly, a direct link between the amount saved and the amount that can subsequently be consumed. If social retirement payments are financed on a strictly pay-as-you-go basis, the retirement consumption obviously represents transfers from those currently employed to the retired. Political considerations aside, whether or not retirement income can increase without putting a greater burden on the presently employed than what the recipients bore when they were employed, depends upon whether the per capita pool of fluid capital has increased – i.e., whether there has been economic growth.
1
I am ignoring retirement saving which occurs through private or public group pension plans. Financed in this context means goods released by the positive saving elsewhere in the economy.
2
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If, as at present in the United States, the Social Security Fund runs a surplus, then whether the surplus can finance an increased level of retirement consumption relative to the present will depend upon what happens to the surplus. If the surplus (whether directly or indirectly) is productively invested in newly produced means of production, then increased retirement consumption is obviously possible without burdening future working generations. However, if the surplus is used to finance current government operations or for transfer payments to those with marginal propensities to consume that are greater than of those who pay the Social Security taxes, this will not be the case. Future generations will, in fact, be burdened.3
12.2
Questions Related to Position Goods
In his book, Social Limits to Growth (1976), Fred Hirsch introduces the notion of a position good as follows: Certain goods and facilities from which individuals derive satisfaction are subject to absolute limitations in supply, deriving from one of a number of sources. The first though not the most significant such source of scarcity is physical availability. Absolute physical scarcities have more usually been considered from the side of production. Thus, the limited availability of land was the centerpiece of classical economics as developed by David Ricardo and, from a different standpoint, by Thomas Malthus some 150 years ago. Equally, concern about the implications of limited resources of agricultural land and of natural raw materials is at the center of the contemporary environmentalecology movement, with its stress on physical limits to growth. To economists, the implications of these physical limits are not as clear-cut as they appear to natural scientists and laymen, because of the potential – and at any given time unknowable – scope for substitution. . . Though economists do not find it possible to make positive predictions on the implications of limited natural resources for the long run future and the possibilities of human survival, there is a less apocalyptic connection between absolute scarcities and economic growth. Insofar as the scarcities are themselves objects of consumption rather than factors of production, scope for substitution on the side of production disappears. In this sense, absolute limitations on final consumption possibilities are in economic terms “more” absolute than similar limitations on factors of production. An acre of land used for the satiation of hunger can, in principle, be expanded two-, ten-, or a thousand-fold by technological advances. These advances may occur in one or all of the processes that come between the productive agricultural use of that acre and the end product in the form of nutrient. From the same productive acre, more and more food can be and has been produced. By contrast, an acre of land used as a pleasure garden for the enjoyment of a 3 In a Newsweek article in 1967, Paul Samuelson wrote: “The beauty about social insurance is that is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in.” This beneficence is possible, Samuelson goes on to say, because “the national product is growing at compound interest and can be expected to do so for as far ahead as the eye cannot see. . . . A growing nation is the greatest Ponzi game ever contrived.” [zQuoted also in The New York Times Magazine, August 27, 1995, p. 56.] Samuelson’s contention that the national product will continue to grow exponentially obviously requires that savings be productively invested. See Appendix D for a proposal for reforming Social Security that, among other things, makes the program self-financing.
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single family can never rise above its initial productivity in that use. The family may be induced or forced to take its pleasures in another way – substitution in consumption – but to get an acre of private seclusion, an acre will always be needed. The significance of this distinction is that it marks the existence of absolute scarcity in one economic dimension, namely consumption. It is with this type of insufficiency, stemming primarily from social rather than physical limitations, that this book is essentially concerned. Hirsch (1976), pp. 19–20.
In his categorization of consumption position goods, Hirsch distinguishes between consumption goods which are physically in fixed supply and consumption goods for which the scarcity is socially induced. Examples of the former would be a Rembrandt painting or exclusive access to a natural landscape which is physically unique. In these cases, consumers derive at least part of their satisfaction from just the inherent characteristics of the goods – i.e., from the painting simply as a painting or acres simply as acres, rather than as objects that are scarce. However, with the second category of consumption position goods: . . .consumer demand is concentrated on particular goods and facilities that are limited in absolute supply not by physical but by social factors, including the satisfaction engendered by scarcity as such. Such social limits exist in the sense that an increase in physical availability of these goods or facilities, either in absolute terms or in relation to dimensions such as population or physical space, changes their characteristics in such a way that a given amount of use yields less satisfaction. This is equivalent to a limitation on absolute supply of a product or facility of given “quality,” and it is in this sense that it is regarded here as a social limitation. This social limitation may be derived, most directly and most familiarly, from psychological motives of various kinds, notably envy, emulation, or pride. Satisfaction is derived from relative position alone, of being in front, or from others being behind. Command over particular goods and facilities in particular times and conditions becomes an indicator of such precedence in its emergence as a status symbol. Where the sole or main source of satisfaction derives from the symbol rather than the substance, this can be regarded as pure social scarcity. Such satisfaction may also be associated with absolute physical scarcities. Thus to at least some people, part of the attraction of a Rembrandt, or of a particular natural landscape, is derived from its being the only one of its kind; as a result, physically scarce items such as these become the repository of pure social scarcity also.... Hirsch (1976), pp. 20–21.
The preceding paragraphs should suffice in establishing the basic ideas underlying position consumption goods, so that we can now turn to the factors governing their valuation. Since Old Masters are clear instances of position goods, and as the factors that determine the values of Old Masters have already been analyzed in detail in Chap. 7, the task here is relatively easy. We need only to summarize the basic principles involved and then extend these to the valuation of position goods in general. As we saw in Chap. 7, a positive value for an Old Master derives from the pool of savings which forms the claims side of the pool of fluid capital. In principle, there is no difference in this regard between an Old Master and any other asset, the only essential difference being that Old Masters do not in general yield a prospective stream of quasi-rents. The willingness-to-pay for an Old Master (as an investment),
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accordingly, will be determined by the amount (appropriately discounted) that a prospective purchaser expects that someone else will be willing to pay at some time in the future, or (if investment per se is not the motivation) by the maximum amount that a prospective purchaser is willing to pay simply for sake of ownership. Extension of these considerations to position consumption goods is in general straightforward. As with any asset, two necessary conditions must be in place for a position good to come into existence with a non-zero value. The first condition is that the good must satisfy some want, either as an end in itself or as a potential investment, while the second condition is that there must exist a non-empty pool of fluid capital. The former provides the motivation for owning, while the second provides the wherewithal for actually doing so.4 As the concern in this section is not with the how and why position goods exist, but only in their existence as such, we can, without loss of anything essential, extend our concept of Old Masters to cover position goods in general. With this extension, it is clear from the discussion in Chap. 7 that the aggregate valuation of position goods is subject to the usual constraints imposed by the pool of fluid capital. At any point in time, position goods compete with all other assets for the pool of unexercised claim tickets defining the claims side of the pool of fluid capital. The sum total of all asset values (which will include the aggregate value of all position goods) will accordingly be bounded by the aggregate value of the pool of fluid capital.5
12.3
Questions Related to Engel Curves and Income Elasticities
As was noted in the introduction to this chapter, the economic drivers in an economy have been seen in this book in terms of the owners/operators of existing productive capacity deciding how much of that capacity to utilize in current production, entrepreneurs deciding how much to invest in new capacity, and households deciding how much of their incomes to consume. Of the three, the last (as recognized by Keynes in the General Theory) is the ultimate mover of economic activity. If operators of existing productive capacity do not believe that current 4 A problem at the micro level in analyzing position goods is an interdependency of tastes and preferences. Collectibles, which are obvious instances of position goods, provide an excellent general example. For many collectibles, a (potential) collectible will have value for a particular “collector” only if it is thought that there is at least one other “collector” who wants the good as well. In short, unavailability for others who want is what drives the desire to have! 5 A van Gogh can bring $82 million in today’s world, not because it is intrinsically worth (whatever that might mean) this amount, but because the world pool of fluid capital is sufficiently large to support such a value. Let there be a worldwide famine (or earthquakes which completely level Japan, the United States, and Western Europe), and the price of the van Gogh would plummet. On the other hand, let there be strong economic growth in the world for the next 20 years, and a painting (though not necessarily the van Gogh) 20 years from now could easily bring upwards of a billion of today’s dollars!
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production can be sold remuneratively, and if those looking to invest in new capacity do not believe that future production can be sold remuneratively, then current capacity will not be utilized and future capacity will not be added to. In both cases, propensities to consume are of paramount importance. For reasons emphasized by Keynes, the propensity to consume out of current income is a prime determinant of the current level of economic activity, while the expected propensity to consume out of future income is a critical determinant of investment in new capacity. A point that is generally not well understood is that economic growth requires the existence of goods with income elasticities of demand in excess of one. If this were not the case – i.e., if all income elasticities were less than one – the aggregate average propensity to consume would be falling, and growth would stagnate as there would be nothing to stir the “animal spirits” which drive investment. A constant emergence of “luxury” goods accordingly provides the sine qua non for sustained economic growth, as ever increasing investment is needed in order to provision their production. An obvious question is whether such a continuing appearance of “luxury” goods can, in fact, be expected to occur. In my opinion, the answer is clearly in the affirmative, and the argument, briefly, is as follows.6 In contrast to traditional demand theory, my view is that an individual’s main preoccupation is how to spend time rather than income. Unlike income, for which most people have to work, time appears each day as a gift. The amount is fixed and its receipt cannot be escaped. The physiology and psychology of the human organism is such that unless a certain number of neurons are firing at any time, the individual is uncomfortable. In psychological terms, arousal is at too low a level. In general, stimulation in some form is required in order to maintain arousal, and much of this occurs through the consumption of market goods and services. Since goods and services are scarce, some of an individual’s time must be spent in acquiring the income needed for their purchase. When not asleep or at work, however, the basic question facing the individual is how to allocate time amongst consumption activities in order to maintain an acceptable level of arousal. In general, an acceptable level of arousal will involve combining novelty with redundancy, where redundancy in this context refers to the amount of familiarity in a consumption activity and can be identified with what Stigler and Becker (1977) define as consumption capital. Too much redundancy leads to boredom because everything has an aura of deja vu (or “familiarity breeds contempt”), while too much novelty leads to confusion and immobility because one does not know what to expect. Some surprise is highly desirable, but too much causes discomfort because of limited capacity to process new information. Redundancy is created through exposure, and arises through the internal dynamics of a consumption activity. The quest for novelty, in contrast, is seen as inhering in the psyche. It functions independently of exposure (although exposure to a new activity can remind
6
See Taylor (1987, 1988, and 1992) and Taylor and Houthakker (2010). Cf., also, Scitovsky (1976).
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one how pleasant novelty can be), and provides the motivation for seeking new activities. It is the raison d’etre for wants being endless, and continually incites the appearance of new goods. Unboundedness of wants in conjunction with an unceasing desire for new activities and goods, in turn, is what underlies a continuing emergence of goods with income elasticities in excess of one. And it is the recognition of this on the part of entrepreneurs that draws new investment into the production of these goods.7
12.4
The Hierarchical Nature of the Pool of Fluid Capital
In Chap. 2, it was noted that the first fluid capital to come into existence as an economy emerges from an economic state will consist of basic necessities like food and shelter. As a primitive economy progresses, however, inventories of storable consumables come to be included in the pool of fluid capital as well. For the island economy described in the Prologue, the fluid capital in existence at the end of the tales consisted of bread, any paintings that Georgia may have had in inventory, and gold. From this, it is clear that the goods represented in fluid capital reflect a hierarchy of consumption wants, with goods that are basic to physical survival at one end of the hierarchy and goods that (for some) may be important to psychological survival at the other end. Bread is needed for physical survival, but paintings and gold are not. The upshot is that the goods in the pool of fluid capital will be much more heavily weighted toward goods needed for basic survival in a poor economy than in a wealthy economy. This consumption hierarchy is a straightforward reflection of the factors just described, namely, unbounded wants in conjunction with an unceasing appearance of new goods. An obvious implication of the consumption dynamics generated by these factors is that, as an economy progresses, goods satisfying higher-order wants become increasingly important in the pool of fluid capital. Stores of food grains (or equivalent access to the same through imports) will figure much more prominently in the pool of fluid capital in a poor economy than in a wealthy one. The consumption hierarchy is also manifested in the valuations of assets, especially for those assets which are in the form of position goods. Old Masters provide a good example. As has been noted at several points in these pages, high valuations for Old Masters are in general possible only in economies that have substantial pools of fluid capital, and are underwritten by a similar (if indeed not 7 An important implication of this section is that necessities (income elasticities less than one) in a high-income economy can be luxuries (income elasticities greater than one) in a low-income economy. A television set is a necessity for a household in the United States, but not in Indonesia. Consequently, what are mature markets in rich countries can be important growth markets in poor countries. Recognition of this disparateness in income elasticities has been a major factor in many of the “Asian miracles” in the 1980s and 1990s. For an entertaining account of such income elasticity “arbitrage,” see Thurow (1999, Chap. 3).
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the same) hierarchy of wants which fuels the continual demand for new goods. Real properties in places with great natural amenities are yet another example. Properties in areas such as Aspen and Jackson Hole could have been acquired for the payment of delinquent taxes during the 1930s, but became expensive position goods after World War II as economic growth increased incomes to the point where wants associated with the ownership of grand second homes could be satisfied.
Chapter 13
Questions Related to Economic Growth
In this chapter, we shall turn our attention to economic growth.1 There are obviously a variety of ways that economic growth can be defined, but the definition that shall be used in this chapter is an increase in income per capita.
13.1
The General Mechanics of Economic Growth
Assuming that an increase in income does not occur simply by people working longer hours or (if paid by piece-rate) by working harder, the only way (in a closed system) that economic development can occur is through investment in additional produced means of production. An increase in the produced means of production increases an economy’s capacity to produce and, therefore, the potential for generating increased income, not only in total but per capita as well. However, investment in produced means of production only leads to the possibility for economic growth. Whether or not this possibility will be realized will depend upon whether the additional capacity to produce is actually utilized, for income is generated only when there is production. On the other hand, for production to take place, owners of productive capacity have to be convinced that the output can be sold, or at least have expectations that it can be sold.2 If the output is sold at a compensatory price, then economic growth can be said to have occurred. Continued growth, though, obviously requires that what has just been described takes place continually.3 1 Throughout this chapter, economic growth and economic development will be used interchangeably. 2 The expectations at issue here are not the same ones that drove the decision to invest in new capacity in the first place. The latter expectations were in place yesterday, and there is no guarantee that they have survived intact till today. 3 Cf. the discussion in Chap. 12 concerning the importance of a continuing appearance of goods with income elasticities of demand that are greater than one.
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Economic growth clearly leads to increases in the pool of fluid capital. Indeed, one can equivalently describe economic growth in terms of an increase in the pool of per-capita fluid capital.4 This is similar to, but not the same thing as, an increase in the capital/labor ratio in conventional growth theory. The phenomena are similar in that both require investment in produced means of production, but are different in that capital in conventional growth theory refers to physical capital as an input into an aggregate production function, whereas capital here refers to fluid capital. The stock of produced means of production is clearly enlarged by investment – indeed, this as noted is a necessary condition for growth to occur – but growth in the present context is not seen just in terms of an increase in the amount of physical capital per unit of labor. Because of diminishing returns, economic growth in conventional growth theory as a result of capital-deepening is taken as being limited, so that the bulk of economic growth is viewed as arising from upward shifts in the aggregate production function – that is to say from technological change. In the present context, technological change is, indeed, a prime force in growth, for technological change makes newly produced means of production more productive than existing produced means of production and can also (through upgrading and retrofitting) make existing productive capacity more efficient as well. In fact, technological change can lead to economic growth even in the case where all investment is strictly for replacement of existing productive capacity. To see this is straightforward. Assume a constant price level, so that in the absence of technological change a current dollar will buy the same amount of produced means of production as an “old” dollar at the time it was invested. Assume that the “old” dollar is returned to the pool of fluid capital through a myros recovery charge, and is now available to fund new investment. Assume that the old produced means of production in question are now replaced dollar-fordollar by new investment. However, with technological change, the newly produced means of production are more efficient than those replaced. Hence, the current capacity to produce will be increased even though, in terms of dollars, the amount of fluid capital sunk in investment is unchanged. One of the beautiful things about investment that increases the capacity to produce is that utilization of the new capacity generates an additional amount of income just equal, in current prices, to the value of the increased output. Obviously, if the increased output is shoes (say), the shoes are all not going to be sold to those who received the additional income from their production. But this is not the issue. The important consideration is that production from enlarged capacities to produce necessarily, and always, generates just the right amount of income in principle
4 Alternatively (and almost equivalently), economic growth can be defined in terms of the increase in real output per unit of labor input – i.e., increases in labor productivity. Accordingly, to explain income and output differences across countries in terms of productivity differences essentially entails a tautology and is, therefore, not very informative. Hall and Jones (1999) offer a recent example.
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to take that production, measured in current prices, from the market. Whether this income is actually spent is, of course, another matter. To summarize the foregoing: 1. Economic growth requires investment in produced means of production. 2. Investment requires fluid capital for finance, which in turn requires saving, either out of current income or out of income at some point in the past. 3. Increased produced means of production provides the potential for economic growth. For the growth to be realized, the increased capacity to produce must be utilized and the increased output resulting there from must be purchased at compensatory prices. 4. Continued growth requires that this process be continually repeated.
13.2
Some Basic Truths Concerning Economic Development
A few fundamental “truths” would seem to be apparent at this point concerning economic development. The first truth is that investment cannot take place in the absence of a pool of fluid capital. Saving must occur before there can be an escape from an economic state of nature. However, once a pool of fluid capital exists, investment – and therefore economic development – can occur in the absence of current saving. A second truth is that economic development can occur only through investment in produced means of production that is funded out of the pool of fluid capital. Related to this fact – but also a third truth – is that, not only investment, but current production as well, must be funded out of the pool of fluid capital. A fourth fundamental truth is that the first three truths are independent of the institutional structure that an economy might have. For an economy to grow a pool of fluid capital must be formed and there must be investment from this pool in produced means of production. This must be the case no matter how the economy is organized – whether market or command – or what form property rights take – capitalist, socialist, etc. Different names might be used, but the fundamentals of growth are the same no matter what “ism” constitutes the organizing structure. Obviously, however, it does not follow from this that economic development in terms of speed and type (or composition) is independent of how economic activity is organized or how property rights are structured.
13.3
Keynes and Economic Bliss
Of all Keynes’s assumptions about real-world behavior in the General Theory, the one I find most indefensible is his belief that two or three generations of stable economic growth would drive the marginal efficiency of capital to zero, at which
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point capital would cease to be scarce. For this to occur, it has to be assumed that individual wants are bounded, but this assumption is clearly unwarranted in my opinion.5 Although it may be true for some individuals, it is not universal, and it certainly does not apply across generations.6 What might be a luxurious level of living for one generation may be scarcely tolerable for a subsequent one.7 As a consequence, I think Keynes was far too pessimistic in the General Theory concerning long-run accumulation. Given proper incentives to save and invest, I see no reason why accumulation should weaken for generations to come. In my opinion, this part of Keynes’s analysis reflected, perhaps more than anything else in the General Theory, his Cambridge and Bloomsbury attitudes of “what ought to be.” Clearly related to this point is Keynes’s view on the need to socialize investment. Certainly, it is true that there are great needs for certain forms of public investment, but this is an entirely different matter than concluding that all investment should be governmentally directed. In my view, the role of government in relation to private investment should be to foster incentives and provide appropriate rules of the game. Private investment will then be in a position to respond to the unboundedness of wants. And I see no reason why, if appropriate incentives are in place, expectations – and therefore investment – will not respond.
13.4
The Endogenous Nature of Economic Growth
The present time is one of considerable reassessment in the study of economic growth. The conventional neoclassical models of the Solow–Swan type in which the prime driver of growth – technological change – is exogenous are giving way to models in which the main driving forces are taken to be endogenous.8 Although I think that the research coming out of this reassessment is extremely useful and beneficial, the models that are emerging are still burdened, in my opinion, with aggregate production functions, a substance theory of capital, and a continuing predilection that an economy can be modeled as though it were a nineteenthcentury energy system.
5 Cf. the discussion in Chap. 12. For discussions of the unboundedness of wants, see (among others) Georgescu-Roegen (1954) and Ironmonger (1972). See also Hawtrey (1925). 6 Moreover, even the assumption of a decreasing marginal utility of income for individuals is questionable in my view, at least for large changes in income. 7 A minimum standard of living has, on occasion, been cast in terms of what an individual needs in order to appear in public without shame. When I was in early elementary school in rural Iowa, it was not unusual for me or my classmates to wear to school clothes that had been mended or patched. However, by late grade school incomes had advanced to the point where this was considered socially unacceptable. 8 See Lucas (1985), Romer (1986), and Arthur (1989).
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The basic drivers of economic growth, in my view, are two: (1) the unboundedness of human wants in conjunction with a quest for novelty in consumption and (2) those with access to fluid capital who see the opportunity to profit from satisfying these expanded wants. Keynes, as just discussed, overlooked the first driver and as a consequence had to put a heavy burden on the operation of “animal spirits” in motivating investment. In normal circumstances, the two drivers of economic growth operate in tandem: Entrepreneurs see profit opportunities in expanding capacity, and the increased income generated by operation of the new capacity provides the wherewithal for the new wants to be satisfied. This is not to imply, as Keynes put it, that there are no “. . . slips betwixt the cup and the lip,” as crystal balls are never perfect and some expectations will obviously not pan out. But failures of expectations aside, the important thing is that there is a near-mechanical relationship between wants spurring new investment and the income that ultimately satisfies those wants.9 The interaction of these tandem drivers clearly imparts an endogeneity to economic growth: Quests for novelty fuel the expectations that drive investment, investment expands the capacity to produce, operation of the expanded capacity to produce generates additional income, which in turn allows the original “quests” to be satisfied. The stage is then set for a new set of quests for novelty to come into play, and the process begins anew. The resulting path of economic growth may be higgledy-piggledy, but it is nevertheless largely endogenous.
13.5
The Role of Technological Change
Earlier in this chapter, it was noted how technological change embodied in newly produced means of production can lead to economic growth through a simple recycling of the pool of fluid capital. Technological change can thus enable economic growth to occur even in the presence of zero net saving. The real essence of technological change, therefore, is that it increases the productivity of the pool of fluid capital. In conventional growth theory, the productivity-enhancing effects of technological change are usually cast in terms of whether technological change is embodied or disembodied. Embodied technological change is described in terms of shifts in the entire production function, while disembodied technological change is seen in terms of factor augmentation. In my view, all technological change is embodied in new investment, and whether the embodiment takes place in physical 9
It might be thought that this is simply a restatement of Say’s Law, but I do not see the point in these terms, as it is the expectation of demand that drives supply, rather than supply which creates demand. The only sense in which demand can be said to be created is in terms of the income that new production generates, which in current prices is just equal to the value of the new production. Whether or not the new income is spent is another matter. Expectations can fail, and at times massively so. This, of course, was one of the great insights of Keynes in the General Theory.
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or human capital is of no great consequence to the theory, for in most cases the investment will involve elements of both. Neoclassical growth theorists, as well as Schumpeter before them, are clearly correct in focusing on technological change as a prime factor in economic growth. In my view, however, it is better to see technological change as an enabler of growth, rather than a driver, in the sense that unbounded wants and “animal spirits” are drivers. By making fluid capital more productive, technological change allows (a la Schumpeter) for existing goods to be produced more cheaply and for new goods (in response to incessant quests for novelty) to be produced in the first place.
13.6
Investment in Research and Development
In a paper given at an OCED Conference on Information Technology in Toronto in late June, 1995, Charles Hulten made the point that investment in R&D has to be paid for in the sense that consumption or other investment is reduced. This fact puts R&D investment on the same footing as any other form of investment in terms of the conditions that have to be met in order for the investment to take place. As investment in R&D requires consumption of fluid capital, the question emerges of how the fluid capital that is sunk in R&D is eventually to be repatriated. Clearly, this has to occur through charges against current earnings, but it is not always clear which earnings are to be charged. For R&D that results in patents, the quasi-rents associated with the patents can be charged, but for R&D that does not give rise to patents, the investment expenditures involved can be repatriated only via overhead charges. In general, the new endogenous-growth literature makes economic growth endogenous by endogenizing investment in education and investment in R&D. Since investment in education and R&D leads to technological change, the “mannafrom-heaven” aspect of technological change in the Solow–Swan growth models is thereby eliminated. Growth is made endogenous by the fact that investments in education and R&D have to compete with all other forms of investment. The equilibrium rate of growth will therefore be determined by the condition that rates of return are equalized. However, the problem with this approach to endogenous economic growth is that the analysis continues to be conducted within the framework of an aggregate neoclassical production function. Capital, whether human or nonhuman, remains something that can be objectively measured, and standard type of time invariances are assumed to exist.10
10
See Appendix A.
13.7 Economic Growth in Reverse: Large-Scale Disasters in Low-Income Economies
13.7
167
Economic Growth in Reverse: Large-Scale Disasters in Low-Income Economies11
In this section, I want to turn to an analysis, using the constraints imposed by the pool of fluid capital, in which a low-income economy is devastated by a large-scale natural disaster. While a crop failure will provide the frame of reference, the principles involved are general, and can be applied equally to phenomena such as earthquakes, floods, or war. As always, when contemplating the impact of a macro event on an economy, the appropriate analytical procedure is to trace out the effects of the event on the pool of fluid capital. For concreteness in the discussion to follow, let us suppose that the economy in question is low-income but above subsistence, primarily agricultural, that the economy is monetized, and that all money is bank money created initially for the purpose of financing production. Assume that there are two agricultural regions in the country with trade between them, that some farmers own their land while others rent, that existing stores of grain are owned by both farmers and merchant middlemen, that besides land and grain the only other assets owned by farmers are draft animals and Old Masters.12 Finally, assume that there is a complete crop failure in one of the regions, but a normal harvest in the other. Under the conditions postulated, the following effects will take place: 1. There will be a reduction of goods in the pool of fluid capital by the amount of the failed crop. 2. Initially, aggregate demand will exceed aggregate supply by the amount of the failed crop measured in current prices. 3. Initially, there will be a “monetary overhang” by the same amount. 4. The price of grain will go up by an amount sufficient to eliminate the monetary overhang. 5. There will be a transfer of wealth from the farmers in the region experiencing the crop failure to the farmers in the other region and to those owning existing stores of grain. 6. The price of draft animals and Old Masters will fall. First – and foremost – the pool of fluid capital will be reduced by the amount of the crop failure, and it is from this that everything else follows. The destruction of goods by the crop failure implies a like reduction in aggregate supply, but there is no offsetting reduction in aggregate demand. This is because the purchasing power created in anticipation of normal harvests continues to exist. While bank money is always dated in the sense that the loans that created it are expected to be repaid out of revenues generated by the production they financed, this cannot happen in the case of a crop failure, because with no grain there are no revenues. As a 11
The analysis in this section is due to numerous discussions with Barbara N. Sands. Obviously, most farmers in a low-income economy do not possess Old Masters. Old Master in this context is intended to refer to any non-income-generating asset that can be exchanged for money. 12
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consequence, the loans are not repaid and the money they created continues to exist as a monetary overhang. Aggregate demand is, therefore, not destructed in linewith the reduction in aggregate supply, so there will be excess aggregate demand equal to the value of the failed crop measured in current (i.e., pre-crop failure) prices. With diminished stocks of grain because of the crop failure, but an undiminished pool of purchasing power, the grain that escaped destruction must go up in price. What really takes place, however, is that the rising price of grain reduces the real value of the pool of purchasing power to a level commensurate with the (now) reduced stock of goods in the pool of fluid capital. The increase in the price of grain is initiated by those experiencing the crop failure, who must purchase grain in order to subsist. To finance their purchases, the farmers in question have to acquire money, either by tapping into their money reserves (should they have some) or by selling draft animals or Old Masters. The prices of these assets must accordingly fall. However, in keeping with the “consumption hierarchy” that implicitly underlies asset valuations,13 the price of Old Masters will almost certainly fall more than the price of draft animals. The grain price increase and the asset price decreases triggered by the crop failure are manifestations of the dual conservation laws imposed by the pool of fluid capital. The former reflects the bound that the pool imposes on the real stock of money, while the latter reflects the bound that the pool imposes on the sum total of asset values. Since fluid capital is destroyed by the crop failure, the monetary overhang that is temporarily created has to be destructed through inflation in the price of grain, while the sum total of asset values has to adjust downward through decreases in asset prices. From the foregoing, it should be clear that, after the crop failure occurs, there is some transfer of wealth from those who do not have grain to those who do. However, one thing that has to be remembered in all this is that, when something like a crop failure occurs that reduces the pool of fluid capital, the rich get richer and the poor get poorer only in a relative sense, not in an absolute sense. Certainly the poor get poorer in an absolute sense and some individuals may be made absolutely better off as well, but since the economy as a whole is impoverished, both the rich and the poor, as groups, are made worse off. Finally, although the analysis in this section has been about a crop failure, the principles involved are perfectly general, and can be applied to any event that causes a destruction of fluid capital – earthquakes, floods, wars, etc.
13.8
Economic Growth and Different Stages of Development
One of the major conclusions that emerges from the analysis of this book is that the conservation laws imposed by the pool of fluid capital are independent of the stage of an economy’s development. Economic growth requires an increase in the pool of 13
See Chap. 12.
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fluid capital, and for this to occur there must be saving and investment. There is, therefore, no “secret” or “holy grail” of economic development, no secret formula of growth that is applicable to a poor economy but not to a rich economy. The only secret is an open one: For growth to occur, there must be in place policies that foster the formation of fluid capital and its subsequent investment in produced means of production.14 Of course, this is not to say that either the relevant policies or the forms that investment should take are invariant to the stage of development. A low-income country with a poorly educated population and a limited and primitive communications system (say) obviously requires different forms of investment than a rich country with a highly educated labor force and a ubiquitous communications system that is at the cutting edge of technology. However, the basic principle is the same: Economic growth requires saving and investment.15
14 I have always been perplexed by the implication of neoclassical growth models of the Solow–Swan type that the equilibrium rate of growth is independent of the rate of saving. As a statement about the real world, this has to be nonsense. In the framework of this book, the growth rate depends on both saving and investment. If both are high, then growth will be high. To me, at least, this is merely common sense. 15 The search for a “chemistry of growth” nevertheless remains an ignis fatuus, a deceptive hope. In a review of the recent book by Ashish Arora, Ralph Landau, and Nathan Rosenberg (Chemicals and Long-term Economic Growth, Wiley Interscience, 1999), in The Economist (March 6–12, 1999), the author of the review states: “Despite the effort expended over many years on understanding it, economic growth remains a mystery. And the harder you look, the more complicated it becomes.” How to put policies in place that foster saving and investment may be difficult, but the mechanics of growth are not themselves a mystery.
Chapter 14
Themes and Counterthemes: Fluid Capital in Retrospect
In general, this book has involved exploration of themes related to fluid capital. More explicitly, it has examined the implications of three definitions, one relating to a concept of capital and the other two relating to two macroeconomic identities. The definition of fluid capital provides a root concept of capital from which virtually all existing notions of capital can be connected and rationalized. The two identities, in contrast, involve equalities between the value of production in current prices and the income the production generates, and between the value of goods in the pool of fluid capital and the corresponding value of claims on the same. From the two identities, it is possible to deduce a number of constraints that the pool of fluid capital imposes on the macro economy. Included among these constraints are: 1. The pool of fluid capital evaluated in current prices provides an upper bound on the real value of the stock of money. 2. The pool of fluid capital evaluated in current prices also provides an upper bound on the aggregate value of an economy’s assets. From these constraints, one can further deduce that, while real-balance effects can exist for individuals, this cannot be the case for the aggregate. Accordingly, the neoclassical conclusion that an economy (with fiat money in its coffers) will necessarily tend toward equilibrium at full employment because of the operation of a real-balance effect cannot be supported. As a consequence of the constraints that the pool of fluid capital imposes on an economy, fluid capital is seen as being conservative at a point in time, but not between points over time. This is because an economy is not a closed system, but alters over time because of saving and investment that cause changes in the volume of fluid capital, uncertainty that causes failures in expectations, and changes in tastes and preferences that (among other things) cause changes in asset valuations. The upshot, accordingly, is that an economy cannot be analyzed as though it were a nineteenth-century energy system. The fact that this cannot be the case has been one of the primary themes of the book. A second primary theme has been that money is a social invention that comes into existence as a means of circumventing the inefficiencies of barter. Not only L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_14, # Springer ScienceþBusiness Media, LLC 2010
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does money make exchange more efficient, it also provides a device for making fluid capital truly fluid, in the sense that the goods in the pool can “flow” efficiently into current production or into newly constructed produced means of production. As money represents the liquification of the goods in fluid capital, money is seen as a pool of purchasing power that is constantly being created, extinguished, and created anew. Its creation, moreover, is viewed as being endogenous. Two rates of interest are relevant. The natural (or real) rate of interest represents the price that equates the demand for fluid capital with its supply, and the money rate of interest that represents the price at which the pool of fluid capital is monetized. Equilibrium in the framework of this book can be characterized in three equivalent forms: (1) in terms of the equality of aggregate demand and aggregate supply, (2) as the equality of inflows and outflows from the pool of fluid capital, or (3) in terms of a stable general price level. However, unlike in conventional macroeconomic theorizing, the determination of equilibria has not been center-stage in this book. In general, equilibria have been seen in terms of “magnets” (or “attractors”) toward which economic activity is drawn. Properties of equilibria, however, have generally been ignored. As with Keynes in the General Theory (but unlike in standard neoclassical macroeconomics), the framework of this book allows for equilibria at less than full employment. And since saving and investment are just two of the flows into and out of the pool of fluid capital, it is also possible for equilibria to occur in which saving and investment are unequal. Aggregate demand and aggregate supply in this book are not seen as schedules in which physical measures of aggregate output are related to a measure of the general price level. Aggregate demand is depicted, instead, in terms of the pool of purchasing power created in anticipation of current production, while aggregate supply is described in terms of the stock of currently available goods evaluated at current prices. The general price level is then seen as being determined through the interaction, per these definitions, of aggregate demand and aggregate supply. If the pool of purchasing power that has been created is greater than the stock of goods currently available at current prices, some prices will increase. On the other hand, if the pool of purchasing power is less than the stock of currently available goods evaluated in current prices, some prices will decrease. The general price level as seen in this book is, accordingly, nothing more than the equilibrium value (i.e., the monetary value) of currently available output. As was noted in Chap. 3, aggregate demand and aggregate supply can differ because the expectations that drive aggregate demand may be different from those determining aggregate supply. The expectations driving the current availability of goods are always those that are in place roughly one-half of an average production period in advance of the expectations that create the current pool of purchasing power. Because the two sets of expectations will almost never coincide, the result will be a general price level that is constantly in a state of flux.1
1
As should be evident from these paragraphs, it is inappropriate in my view to measure changes in the general price level in terms of standard Laspeyres price indices. Only current-quantity weighted chain indices provide meaningful measures of inflation and deflation.
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One of the mainstays of traditional monetary theory is a separation (or “dichotomy”) between the real and monetary sectors. Relative prices are seen as being determined in the real sector, while the general price level is seen as being determined in the monetary sector. A constantly recurring theme in this book has been that money is not exogenous to the level of economic activity, but rather is handmaiden to it. Money created (or alternatively borrowed from existing stocks of money held as an asset) in anticipation of current production forms the pool of purchasing power that fuels aggregate demand, and the general price level emerges from the interplay of this pool of purchasing power with the stock of goods that are currently available. Clearly, if a pool of purchasing is created that differs from the available stock of goods measured in current prices, the price level will change. In view of this, it obviously follows that the general price level is determined by the pool of purchasing power which forms aggregate demand. If too much purchasing power is created, the general price level will rise, and vice versa if too little is created. On the other hand, it does not follow that the neoclassical “dichotomy” will hold, for there is no reason to assume that excess (or deficient) purchasing power will be distributed proportionately across goods. Consequently, one cannot conclude that relative prices will be formed independently of the amount of money that has been newly created.2 A third theme of the book is that the consumption structure in an economy is inherently hierarchical. By this, I mean that as an economy becomes wealthier, goods that have previously been luxuries become necessities, and new goods (or new combinations of existing goods) emerge as luxuries. Among other things, this has important implications for the pool of fluid capital: Fluid capital is such only in relation to the level of income. Food, shelter, and basic clothing will represent a relatively small proportion of fluid capital in a high-income economy, but a high proportion in a low-income one. In view of this, one cannot characterize a priori the goods that constitute fluid capital. The goods that define fluid capital are simply whatever producers and consumers in an economy demand at current prices. Closely related to the third theme is the idea that economic growth, at base, is driven by the demand for goods with income elasticities greater than one. In my view, the constant emergence of such goods is assured by the unboundedness of wants. Once a want is satisfied, another unfulfilled want emerges on the margin, and it is the recognition and anticipation of this that fuels the “animal spirits” underlying investment in newly constructed produced means of production. As development proceeds, moreover, “position” goods come to assume an ever greater importance, especially in the composition and structure of an economy’s assets. Every economy
2
This will be true, moreover, even in situations in which the stock of money is changed exogenously, as was the case, for example, when East and West Germany merged in 1990. Because of the pegging of the two marks at close to par, there was, in effect, a once-and-for-all increase in the stock of marks, with no offsetting increase in the pool of fluid capital. Again, there is no reason to assume that the part of the increased stock of marks that sought outlet against goods would be spread proportionately.
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beyond a subsistence level can have “Old Masters” in some form or another, but only extraordinarily wealthy ones can support $80 million van Goghs and Renoirs. A fifth theme of the book is the importance, in relation to the pool of fluid capital, of fiducial (or accounting) depreciation, as opposed to economic depreciation. In the framework of this book, fiducial depreciation (rather than economic depreciation) is seen as the vehicle whereby capital invested (i.e., sunk) in produced means of production is ultimately returned to the pool from which it came. Economic depreciation is relevant to a number of important decisions, but these are all essentially of the form: How much to produce today as opposed to how much to produce tomorrow, how much to pay for additional capacity, and when is some (or all) of existing capacity to be scrapped? Moreover, none of these decisions actively entails the creation of fluid capital, for there is no necessary connection between the timing of economic depreciation and the timing of “capital recovery” charges (i.e., fiducial depreciation) against quasi-rents. In short, fiducial depreciation generates fluid capital, but economic depreciation does not. A sixth theme of the book is that demands on the pool of fluid capital are multifaceted and include the financing of current production as well as investment in newly produced means of production.3 Indeed, in ordinary circumstances, the amount of fluid capital demanded by the funding of current production will be much greater than the amount demanded by investment. One of the implications of this is that the relationship between investment and the rate of interest need not be negative – i.e., investment functions do not necessarily slope downward. This conclusion follows from the necessity for interest to be paid on both uses for fluid capital (i.e., both investment and the finance of current production) in conjunction with the possible tradeoff between the “capital intensity” of production and the length of the period of production.4 In conventional economics discourse, little or no attention is given to the finance of current production as a demand on an economy’s stock of capital. This would appear to be because capital in most instances is identified with the stock of physical capital, rather than fluid capital; hence, the role that fluid capital plays in sustaining production is usually overlooked. The financing of current production tends to be treated as a monetary phenomenon and its role as an integral part of the operation of the real economy is, therefore, neither appreciated nor understood. Since the framework of this book revolves around fluid capital and two associated identities, the question always to be asked in applying the framework to macroeconomic issues (whether practical or theoretical) is: How is the pool of fluid capital affected? To raise and then answer this question is, in essence, to identify the relevant macroeconomic constraints that are to be taken into account. Once this is done, the 3
That capital has to finance both current production and investment in produced means of production has generally been overlooked in the literature on capital theory. A notable, but partial, exception was R.G. Hawtrey in his two early volumes on the trade cycle, Good and Bad Trade (1913) and Currency and Credit (1919). Hawtrey’s focus, however, was on the general availability of money and credit, rather than the relationship of these to fluid capital. 4 See Appendix B.
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analysis can usually be reduced to a straightforward assessment of the implications and conditions imposed by the constraints. Every question that has been analyzed in this book – from inflation, to the evaluation of Old Masters, to the gold standard, to the burden of the National Debt, to economic growth, to transfer problems, to destruction caused by natural disasters, etc., – has been approached in this framework. And the answers are almost always straightforward and unambiguous. Throughout this book, monetization has been identified with the process whereby specific claims to the goods in the pool of fluid capital are converted into generalized claims through the creation of universal purchasing power. The aggregate value of the goods in the pool of fluid capital, where the goods are valued in current prices, is then seen as providing an upper bound on the real stock of money that can be created. Although the constraints imposed by the pool of fluid capital apply no matter what the monetary system or the actual form that money takes, the perspective of this book has, except for occasional references to fiat money, been that of a banking system that creates universally transferrable deposits. The “money-creation principle” of the book is accordingly that of the venerable English Banking School (or Real Bills Doctrine): Loans should be self-liquidating and if prudence reigns – and expectations are fulfilled! – just the “right” amount of money will always be created.5 The core of current-day macroeconomics, as it is presented in most intermediate textbooks, can be stated in three propositions: 1. There is a lower limit of unemployment, the Non-Acceleration Rate of Unemployment (NAIRU), below which inflation will pick up. 2. There is an upper limit on the growth that an economy can sustain, the “potential rate of growth,” that is determined by the growth of the labor force and the pace of technical change. 3. In the long run, the rate of inflation is determined by the rate of growth of the money supply. Of these three propositions, the only one that is in general agreement with the arguments of this book is the third, that the rate of inflation is determined by the rate of growth of the money supply. Even so, I would prefer to see the proposition reworded to read: 3a. The rate of inflation depends upon the size of the pool of purchasing power that is created in relation to the available stock of goods evaluated in current prices. With respect to proposition (2), if the “potential rate of growth” is taken to mean that the potential is a structural characteristic of an economy, then I disagree with the proposition sharply. An economy grows because of enlargement of the capacity to produce through saving and investment. As technical change is embodied in investment, how potent a dollar of new investment will be in expanding the
5
“Right” in this context is taken to mean that the pool of purchasing power that is created is consistent with a stable general price level.
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capacity to produce will clearly depend upon the pace of technical change, but technical change (as is being emphasized in the New Growth Theory) is itself dependent upon investment, namely, investment in education and research and development. The key, accordingly, is investment, which in turn depends upon the availability of a pool of savings. One economy grows faster than another because the one saves and invests more. Japan and Germany grew much faster than the USA for much of the post-WWII period because of higher saving and investment than in the USA. The USA has grown faster in the latter part of the 1990s than before that because it has invested more. On the other hand, saving and investment are themselves dependent upon expectations, so it is really expectations that drive economic growth. If entrepreneurs invest prudently (i.e., direct their “animal spirits” mostly to areas that produce goods with income elasticities greater than one), then (because of the unboundedness of wants) the new capacities to produce will, in fact, be utilized. In short, there is no upper limit to the rate of growth for an economy. High saving and investment can lead to high growth without inflation. There need be no structural NAIRU. As this book has progressed, some readers may have noticed an evolution in the definition of fluid capital. In the beginning, fluid capital was defined in terms of the unconsumed surplus from current and past production, but with familiarity the term has increasingly been identified with goods in the process of production plus inventories of finished goods. Since, in a high-income economy, the latter will be small in relation to the former, the goods component of the pool of fluid capital in a high-income economy can essentially be identified with goods in process. When this observation is combined with the Banking Principle of money creation, one can then interpret the monetization process as one in which goods are, in essence, transformed into universal purchasing power simultaneous with their production. When cast in this light, money, in conjunction with a well-functioning banking system, has to be hailed an astounding marvel of social invention. Three final comments are in order in closing. The first is that in the many years that I have thought about the topics discussed in this book, I have come to appreciate tremendously the understanding of both Keynes and Schumpeter as to what makes real-world economies tick. Keynes’s focus was almost always on the here and now of economic activity, while Schumpeter’s was usually on an economy’s longer-term evolution. Their concepts of capital are similar (although Schumpeter’s is much better developed), and the same is true of their concepts of money and how money comes into existence. The economics of the two are complementary in my view, and I think it unfortunate that they are often cast as rivals, with strongly conflicting “visions” of what economics is all about and how real-world economies operate. For the most part, they were simply concerned with different questions. The second comment concerns Keynes’s dictum in the General Theory that one must constantly be on guard in macroeconomic theorizing against fallacies of composition. Keynes dispelled a number of such fallacies, and I hope this book has taken care of several more.
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Finally, let me finish with how I began this book, by speaking about the venerable word capital. One of my intents in the book has been to forge a root concept of capital that can rescue the word capital from what has become a scrapheap of overuse and confusion, and imbue it with the possibility of relating the many existing concepts of capital to one another in a consistent fashion. Fluid capital, in my opinion, provides the appropriate instrument. If the ideas in this book should ever catch on, ultimate success would occur if “fluid” in “fluid capital” should become redundant. Capital, without an adjective, could come to refer to fluid capital, as it has been defined in these pages, and all other concepts of capital could then be identified by appropriate adjectives.
Postscript
Except for a footnote here and there, no mention has been made to this point of the financial excesses of 2002–2007 that culminated in the late summer and fall of 2008 in the most severe global economic crisis since the Great Depression of the 1930s. We now turn to an analysis of the tumultuous events of those years, with emphasis on an extremely important characteristic of a monetary production economy that was not given adequate attention in the original text, namely, the interaction between money as a store of value and the mass phenomena of confidence and uncertainty. Establishing the importance of this interaction in conjunction with the real constraints imposed on asset values by the pool of fluid capital is the purpose of the next two chapters. However, the focus in these chapters is not on the detailed events of the crisis of 2007–2009 per se – as a number of excellent chronicles of this already exist – but rather on the development of an understanding of why financial crises are an inherent feature of an economy with money and why their occurrence is unlikely ever to be banished. As much as anything, the two chapters of this postscript represent a disquisition on Keynes’s distinction between risk and uncertainty and why this distinction is key to understanding why financial crises are an inherent feature of an economy with money. The most popular explanation of the 2007–2008 financial meltdown was the failure of banks and other financial institutions to manage the new “risks” posed by financial innovations, specifically in the form of securities backed by sub-prime mortgages and the use of a variety of exotic financial plays and instruments to insure and hedge against default. What was collectively overlooked by financial institutions and regulators alike in the buildup to the crisis was that, while risk can reasonably be managed at a micro level, this is not the case at the macro level. Risk can be spread, but in the aggregate cannot ever be banished, particularly when it shades into and mixes with uncertainty. Keynes, in Chaps. 12 and 17 of the General Theory and (especially) in his defense of the General Theory in 1937 article in the Quarterly Journal of Economics, understood this well, but, because of the insistence in mainstream macroeconomic theory to treat uncertainty mathematically as risk, the importance of Keynes’s insights in accounting for financial crises has only been appreciated and utilized by maverick “Post-Keynesians” like Paul 179
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Postscript
Davidson and the late Hyman Minsky.1 Increasingly, however, it is coming to be understood that the events of late summer and early fall of 2008 was in fact a “Minsky moment” – a time when the conjuncture of fear (from a collapse of confidence), uncertainty, and heightened liquidity preference morphed into a perfect financial storm.2 In the two chapters of this postscript, the following themes will be center-stage: 1. A sharp distinction, as emphasized by Keynes (and Knight before him), between risk and uncertainty. 2. The existence of two aggregate markets in an economy: a goods market and an assets market, the dynamics of which are different. 3. Inherent instability of asset markets because of the interaction of confidence, uncertainty, and liquidity preference. 4. Asset values, both real and financial, derive from the pool of fluid capital, and which in the aggregate cannot increase faster than the rate of growth of income. 5. The interaction of confidence, uncertainty, and liquidity preference. Crises occur when confidence evaporates in the face of uncertainty, and there is a rush by asset holders to acquire money as a store of value. 6. The dangers of allowing new money creation to fuel speculation and wagering in asset markets. “Casinos with banks” have no place in asset markets. 7. Limiting money creation by the banking system to the funding of current production and the initial finance of investment in new produced means of production.
1 2
See Davidson (1978, 2009), Minsky (1975, 2008). See “Minsky’s moment,” Buttonwood, The Economist, April 2, 2009.
Chapter 15
Background and Tools for Understanding and Dealing with Recurrent Financial Crises
The events since 1970 make it clear that current-day mainstream macroeconomics does not provide an adequate framework for dealing with the financial crises that are increasingly part and parcel of free-market economies. As noted by Skidelsky (as well as others), the financial collapse of 2007–2009 reflects in great part “the intellectual failure of mainstream economics.”1 Neither of what are now the two standard textbook macroeconomic frameworks, the New Keynesian and New Classical Models, even admit of the possibility for financial crises to emerge, let alone offer provision for their alleviation.2 The problem is that neither framework allows for money to play its truly unique real-world role, namely, that of a risk-free store of value in the face of uncertainty. Missing, as well, is any notion in either model of a theory of production in which investment is determined not only by present-value considerations, but also by the availability and terms of finance. The purpose of this chapter is to develop a framework, based in substantial part on the long overlooked Chaps. 12 and 17 of the General Theory (and the equally overlooked work of the late Hyman Minsky), in which money and finance, on the contrary, are center-stage in determining the level and pace of economic activity. Our point of departure will be a revisit of uncertainty and liquidity preference as described and discussed by Keynes in Chap. 17 of the General Theory and in his 1937 rebuttal of Viner in the Quarterly Journal of Economics.3
1
Skidelsky (2009, p. 168). These two research programs have essentially dominated academic macroeconomic research since the 1970s. The New Classical Model derives from the “Rational Expectations Revolution” associated with Robert Lucas, Jr., Thomas Sargent, Edward Prescott, Finn Kydland, Robert Barro, and others, while the New Keynesian Model is based upon the thinking of John Taylor, Olivier Blanchard, Gregory Mankiew, David Romer, Michael Woodford and others. Hoover (1988) and Woodford (2003) provide textbook treatments and discussions of the two models. Cf., also, Woodford (2009). For devastating critiques of the current-day conventional macroeconomic theory in terms of its irrelevance to the 2007–2008 financial meltdown, see Buiter (2009), Krugman (2009), Skidelsky (2009), and the July 18–24th, 2009, issue of The Economist (pp. 65–69). 3 Keynes (1937a). 2
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_15, # Springer ScienceþBusiness Media, LLC 2010
181
182
15.1
15 Background and Tools for Understanding and Dealing with Recurrent Financial Crises
The Impact of Uncertainty on Economic Activity
To the three great innovations generally credited to Keynes in the General Theory – the Principle of Effective Demand (i.e., Aggregate Supply and Aggregate Demand), the Consumption Function, and the Liquidity Preference Theory of Interest – a fourth should be added, namely, the Impact of Uncertainty on Economic Activity. In one form or another, aggregate supply and demand, the consumption function, and liquidity preference are all integrated into conventional macroeconomic theorizing and modeling (whether of the Neoclassical Synthesis, Old Keynesian, New Keynesian, or New Classical variety), but this is not the case for uncertainty, which is unfortunate, for the neglect of Keynes’s analysis of the impact of the unknown and unknowable in Chaps. 12 and 17 of the General Theory and his 1937 QJE rebuttal of Viner has meant that conventional macroeconomic theories have virtually nothing to contribute to an understanding of financial crises.4 By uncertain knowledge, Keynes, in his 1937 QJE rebuttal of Viner, says: I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only mildly uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed. Keynes 1937a, pp. 113–114.
Keynes then asked, “How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men?”, and then went on to offer three important techniques (or principles) for doing so.5 The first is simply to assume that the future, without any sound basis whatsoever, will be much like the present. The second is “to assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.” Finally, Keynes’s third important technique for dealing with uncertainty is: Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of
4 This stricture, it is important to note, does not apply (in the United States) to the so-called PostKeynesian interpreters (Paul Davidson, Hyman Minsky, and others) of the General Theory, for whom Chaps. 12 and 17 of the GT play a critical role. 5 Ibid., p. 114.
15.1 The Impact of Uncertainty on Economic Activity
183
individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.
Finally, still quoting Keynes: Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled board room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface. Ibid., pp. 114–115.
This paragraph, perhaps more than any other in Keynes’s writings, holds the key to understanding why financial crises occur, and points up why, for a macroeconomics to have relevance for the real world, the impact of uncertainty on economic activity has to be an integral part of the theory. Financial crises occur primarily because of an interaction between uncertainty and money. In one of Keynes’s most quoted passages, he states: Money, it is well-known, serves two principal purposes. By acting as a money of account it facilitates exchanges without its being necessary that it should ever itself come into the picture as a substantive object. In this respect it is a convenience which is devoid of significance or real influence. In the second place, it is a store of wealth, so we are told, with a smile on the face. But in the world of the classical economy, what an insane use to which to put it! For it is a recognised characteristic of money as a store of wealth that it is barren; whereas practically every other form of storing wealth yields some interest or profit. Why should anyone outside a lunatic asylum wish to use money as a store of wealth? Ibid., pp. 115–116.
The answer, obviously, is uncertainty, that is, not knowing what the future will bring. As Keynes goes on to say (p. 116), “our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future.” The desire to save and to hold wealth is essentially a desire to transfer purchasing power from now until sometime, not necessarily a determinate date, in the future. Many assets, both real and financial, exist by which this can be done. However, when the time comes that the purchasing power being transferred is to be used, it must in general be in the form of money as a medium of exchange. For this to be the case, there must exist a market in which the asset in the transfer can be sold for cash, which is to say that the asset must possess liquidity at some date in the future. In normal circumstances, many assets possess such liquidity, but at a price that is not known today. The peculiarity of money as a store of value is that it is perfectly liquid (i.e., convertible into money as a medium of exchange at a price of one, with no transactions costs). In the absence of uncertainty, that is, if the prices of assets (with positive yields) at all dates in the future were known with certainty, then, as
184
15 Background and Tools for Understanding and Dealing with Recurrent Financial Crises
Keynes noted, no one with their senses intact, would use money as a store of value. However, when these prices are neither known nor knowable, things change, and the perfect liquidity of money provides a bedrock of certainty and trust. Just as money has it peculiarities, so too does uncertainty, in that, while we know it exists, it is essentially impossible to get one’s hands around, and, even worse, its perception can ebb and flow and can change discontinuously virtually instantaneously.6 There can be times of apparent stability, in which expectations are seemingly borne out, and other times when the conventional basis for expectations can change, as with an ever so slight twist of a kaleidoscope.7 Keynes’s liquidity preference theory of interest is based upon the interaction of uncertainty and money as a store of value. Whereas, as has been noted earlier in this book, the classical theory sees interest as the reward for saving, Keynes saw interest as a payment for giving up the liquidity of money. When uncertainty is high, this payment (or liquidity premium) is necessarily high as well. Indeed, it can at times become so high (as in the fall of 2008) that asset markets seize up and borrowing and lending come to a virtual halt. Uncertainty impacts real activity in two important ways. The first is through its effect on the willingness-to-pay for investment in new produced means of production (or what Keynes called the marginal efficiency of capital), while the second is via the terms on which both current production and new investment can be financed. The impact of uncertainty through financial channels will be discussed in Sect. 2 below. In this section, we will examine the impact on the willingness-to-pay for new investment. From Chap. 5, the willingness-to-pay for a particular investment is given by the present value of the stream of quasi-rents that the investment is expected to generate over its lifetime, that is, by: PV ¼
n X
Qi
i¼1
ð1 þ rÞi
(15.1)
where Qi denotes the quasi-rent [i.e., revenues minus the avoidable (i.e., out-ofpocket) costs of production] in period i in the future, n denotes the horizon over which the investment is being evaluated, and r denotes the discount rate. As before, a necessary condition for the investment to be undertaken is that its present value be at least as great as its price (or cost), that is, we must have: PVrC;
(15.2)
where C is the total cost of the investment.
6
Like a fog or vapor that can enter and leave the collective psyche (with apologies to Sandburg) like a “cat on silent little feet.” 7 Cf., Shackle (1974, p. 76). Shackle (1967, Chapter 15) provides (in the author’s opinion) far-andaway the best exposition of the liquidity preference theory of interest, better even than Keynes’s own in the General Theory and his 1937 QJE paper.
15.2 Uncertainty and the Pace of Investment
185
Expression (15.2) describes the necessary condition for investment in an income-producing asset for a given environment of uncertainty, or what Keynes would have called a given conventional basis of evaluation.8 As present value is totally future-looking, a change in basis can impinge upon its calculation in three different places in the formula, namely, in the values of the quasi-rents Qi , in the discount rate r, and in the length of the investment horizon n. In general, an increase in uncertainty will: 1. Reduce the expected quasi-rents.9 2. Increase the discount rate. 3. Reduce the length of the horizon over which the investment is being evaluated. In expression (15.1), we see that each of these effects implies a reduction in present value, and, taken together, they can reduce willingness-to-pay so much that an investment that appeared extremely feasible under an old basis cannot even get out of the starting blocks under a new one.10
15.2
Uncertainty and the Pace of Investment
An often overlooked aspect of investment and production is that, not only do potential income-producing projects have to pass a present-value test, but they also have to be financed. Not only do households have budget constraints, but so, too, do firms (and what, for the moment, we shall euphemistically call “investors”). We have just seen how a change in basis that increases uncertainty can lead to a sharp decrease in willingness-to-pay for income-generating assets (whether they be old or new, real or financial, is immaterial). Equally important, and often even more so, is the impact of a change in basis on the availability of finance. In this section, we will tie together the two necessary conditions for an investment to be undertaken – the present-value test and the ability to finance – in a framework based on Keynes in the General Theory, but in a form primarily associated with the late Hyman Minsky. As a point of departure, let us return to Fig. 5.2 of Chap. 5 (reproduced here as Fig. 15.1), which shows the willingness-to-pay (i.e., demand) to own some particular income-producing real asset. The vertical line labeled S in Fig. 15.1, it will be recalled, represents the existing units of this asset (measured in depreciated units), the downward-sloping line labeled DD represents the market demand for the asset, and the curve label ss represents the flow-supply curve of newly produced units of 8
Or what henceforth will be referred to as simply the basis. Indeed, the usual effect on expected quasi-rents of an increase in uncertainty will be to reduce expected revenues and increase expected avoidable costs, a double whammy that might in itself be sufficient to kill what had been a planned investment. 10 Obviously, these effects are reversed for a change in basis that reduces uncertainty. 9
15 Background and Tools for Understanding and Dealing with Recurrent Financial Crises
Fig. 15.1 The investment decision
Price
186
D
S
Ps
s s
D
q
Output
the asset. As depicted, the point where DD cuts S represents the current spot price ps , which is the price that a firm can add to capacity by purchasing an already existing unit of the asset. However, since the spot price lies above the flow-supply curve on S, it will be cheaper for firms to add to capacity by investing in new units. In the absence of finance constraints, firms in this situation would have incentive to do so (that is, invest in new units) up to an amount q (i.e., up to the point where the curve DD cuts the flow-supply curve ss). The task now is to show how the availability of finance affects this decision. To do this, let us now turn our attention to Fig. 15.2, which shows the investment and finance conditions facing a representative firm utilizing the asset whose market demand is depicted in Fig. 15.1. In this figure, we have prices on the vertical axis and the number of units of investment ðIÞ on the horizontal axis. The horizontal line labeled PK represents the spot price of a unit of existing capacity, while the solid curve labeled PI represents the supply of new investment, both as determined in Fig. 15.1.11 As is now to be emphasized, investment in new capacity to produce has to be financed, which is to say that its cost has to be covered either by using internal funds (i.e., retained earnings) or by external borrowing. For now, we will put to the side the possibility of raising funds through the sale of new equity. The amount of retained earnings available to the firm is represented by the rectangular hyperbola labeled RR, showing the different combinations of PI and I that can be financed by an amount of internal funds R (i.e., PI I ¼ R). From the diagram, we see that an amount I of investment can be financed through internal funds (shown as the point where RR intersects PI . Investment beyond I accordingly requires the use of borrowed funds. Once the firm spends beyond its internal funds, two forms of risk come into play, namely, borrower’s risk and lender’s risk. These are represented in the diagram by the curves labeled BR (borrower’s risk), LR (lender’s risk), and MLR (marginal
11
Cf., Minsky (1975, Chap. 5).
15.2 Uncertainty and the Pace of Investment
187
S R
MLR
PK
PK LR
C
BR
PI A
0
PI
PI¢ R
I*
I1
Investment
I
Fig. 15.2 The investment decision with finance constraints
lender’s risk). While both types of risk were discussed by Keynes in the General Theory, Minsky (1975) describes them in even greater detail: Borrower’s risk has two facets. First, in a world with uncertainty, where the fates of various capital assets and firms can differ, a risk averter will diversify. This means that beyond some point, which for the individual wealth owner or corporation depends upon the size of his wealth, the capitalization rate for any one type of capital asset to be used in a particular line of commerce declines as the amount owned increases. Second, since the borrower sees the cash flows [required to service debts] as certain and prospective yields as uncertain, increasing the ratio of investment that is debt-financed decreases the margin of security and thus lowers the capitalization rate that the borrower applies to the [prospective stream of quasi-rents]. Minsky (1975), p. 110.
Moreover, as Minsky notes: Borrower’s risk is subjective; it never appears on signed contracts. It is a focal point for the “quivers and quavers” [and “sweaty palms!”] of uncertainty and the “surprise” of high animal spirits.
On the other hand: Lender’s risk does appear on signed contracts. For any set of market conditions, lender’s risk, as it applies to a particular firm, takes the form of increased cash-flow requirements in debt contracts, as the ratio of debt to total assets increases. Lender’s risk shows up in financial contracts in various forms: higher interest rates, shorter terms to maturity, a requirement to pledge specific assets as collateral, and restrictions on dividend payouts and further borrowing are some of them. Lender’s risk rises with an increase in the ratio of debt to equity financing or the ratio of committed cash flows to total prospective cash flows. Minsky (1975), pp. 110–111.
Borrower’s risk is represented in Fig. 15.2 by the dashed curve label BR that falls away from PK beyond the point I .12 Lender’s risk, on the other hand, is represented
12
As Minsky mentions, this “falling away” could start even before the point I*.
188
15 Background and Tools for Understanding and Dealing with Recurrent Financial Crises
by the rising curve labeled LR, which begins at I . Note that this curve starts at a point that lies above PI , in reflection of the fact that, for the reasons just described by Minsky, outside funds are more costly to a firm than its own internal funds.13 However, this is not the end of the story for lender’s risk, for as the amount borrowed increases, there is the likelihood that all of the debt issued by the firm will, upon refinancing, have to conform to the marginal contract, in which case, a curve that is marginal to the rising supply curve of borrowing will emerge. This curve, which is the dashed curve labeled MLR (for marginal lender’s risk) in the diagram, thus becomes the curve that is relevant for decision-making. Investment by the firm, for the conditions depicted in Fig. 15.2, will accordingly be pursued up to the point where the two dashed curves, BR and MLR, cross, that is, where the borrower’s and marginal lender’s risk are equal. The total investment will therefore be I, with I financed with internal funds and II financed by debt. Let us turn to what can happen under the assumption that the expectations that drove firms’ investment decisions, rosy as they might have been, turn out to be confirmed (or even more than confirmed), as would typically be the case when the economy enters into a boom. In this situation, both borrowers and lenders become more risk-tolerant, and the borrower’s and lender’s risk curves shift to the right, and perhaps even flatten. Firms, when it comes time to refinance, can do so on better terms, and in all likelihood will have incentive to increase their investments. It is during such times – that is, during times of trust and confidence when (positive) expectations are being borne out causing borrower’s and lender’s risk to lessen (or, at an extreme, to disappear) – that an economy comes closest to getting a “free lunch.” However, as will be discussed in the next chapter, it is virtually impossible for such times to be sustained in today’s highly complex, financially fragile economies.
15.3
Hedge, Speculative, and Ponzi Financing
When a firm makes an investment, it commits itself to a future stream of payments. Whether these commitments can be fulfilled depends upon whether the expected quasi-rents that drives the investment to begin with in fact materialize. More generally, every item on the liability side of a firm’s balance sheet has associated with it a stream of payments, interest, repayment of debt coming due, taxes, payments for materials and services, etc. For the most part, the payments due on an investment are certain, while the income that it produces is purely expectational and therefore uncertain. Minsky identifies three different types of finance for covering and cash payments, namely, hedge, speculative, and Ponzi.14 Hedge finance is where a firm’s receipts are expected to exceed its contractual cash 13
Cf., also, Duesenberry (1958, Chap. 5). See Chap. 4 of Minsky (2008).
14
15.3 Hedge, Speculative, and Ponzi Financing
189
payments in each period. Speculative finance, on the other hand, is where a firm’s expected cash flows are less than its contractual payments, with the difference being made up from the firm’s holdings of cash or from sale of assets. Finally, Ponzi finance is where a firm meets its cash payment obligations through a rolling-over of existing debts or the sale of new debt.15 Since both sides of a firm’s balance sheet entail the future, it is not uncommon for investments that are prudently entered into, especially those involving long-lived physical capital assets, to include elements of speculative or Ponzi finance in the early periods of the horizon. Obviously, however, for an investment to be prudent, the finance has to be of the hedge-type over its lifetime. On the other hand, this is a point where uncertainty comes into play in a major way. For, since cash payments associated with the liability side of a balance sheet are generally certain, while the cash receipts associated with the asset side are expectational, a change in the conventional basis a la Keynes can force firms thought to have been safely engaged in hedge finance into speculative or even Ponzi finance. As will be discussed in greater detail in the next chapter, such is a hallmark of financial panics, and was center-stage in the financial meltdown of 2007–2008 and subsequent recession. In Sect. 2, we saw that, issues of finance aside, uncertainty affects the demand (i.e., willingness-to-pay) for investment at three vital places in present-value calculations: the expected values of the stream of future quasi-rents, the rate at which the quasirents are discounted, and the investment horizon. Uncertainty affects finance, as we have just seen, through its impacts on borrower and lender’s risks. A change that lessens uncertainty can reduce borrower’s risk by making firms’ payment commitments appear more secure, whether through validation of prospective cash flows or increases in the value of financial assets (or both). As cash flows are validated by events, lender’s risk is reduced as well, which may lower interest rates on existing debt, allow for reduced collateral, less restrictive covenants, and easier refinancing, as well as for new debt to be taken on. What had been Ponzi finance may become speculative finance and speculative finance to become hedge finance. Obviously, all of the above can (and usually will) go the other way when there is a change in the conventional basis that increases uncertainty. In this situation, even if nothing should occur to jeopardize cash flows, borrower’s risk will increase as firms become less confident of their expectations, as will lender’s risk as banks and short-term lenders increase rates and demand enhanced collateral and more onerous restrictive covenants. However, there is a major difference in timing between the two impacts, in that the effects of lessened uncertainty are in general greatly delayed in relation to those of heightened uncertainty. For, the effects of the latter, like a flock of birds changing course, can be virtually instantaneous, and firms that had seemingly been securely hedge-financed can suddenly find themselves at the mercy of scared and balky lenders.
15
Public finance becomes Ponzi finance when governments are forced to borrow in order to pay the interest due on the public debt.
190
15.4
15 Background and Tools for Understanding and Dealing with Recurrent Financial Crises
The Many Burdens of Quasi-Rents
For economic growth to occur, there must be investment in new produced means of production and, for this to take place in a capitalist economy, there must be the prospect that the quasi-rents generated by investment over its lifetime not only make the investment whole in terms of its initial cost, but also be sufficient to cover a variety of other payment commitments, such as property and income taxes. The driving consideration is that all commitments, which include many that result from past investment decisions, have to be serviced out of either current revenues or current capacities to borrow. To see what is involved, let us focus our attention on Fig. 15.3, which describes a representative firm’s short-run cost conditions. As in Fig. 5.1 of Chap. 5, the rising curve in this figure represents the avoidable costs of producing output from the firm’s existing capacity (as given by the vertical line atK0 ).16 Where on the avoidable cost curve the firm will operate obviously depends upon the demand conditions that the firm faces. Two cases need to be distinguished, the first being where the firm sells its output in a competitive market. In this case, it has to take its output price as given. In the second case, the firm has some market power and accordingly some choice over the price that is charged.17 Without making a commitment to either type of market, we can construct a curve, as in the one labeled RR in the diagram, that shows the different combinations of price and output that generate an amount of revenue that just covers the payment commitments of the firm as required by the liabilities of its balance sheet.18 Price–output points below this curve yield revenues that are short of the firm’s contractual commitments, while points above this curve will yield sufficient revenues for the firm both to satisfy its payment commitments and to add either to dividends or to retained earnings. The quasi-rents, from which balance-sheet payment commitments have to be met, are represented in Fig. 15.3 as the difference between receipts from sales (plus any income from non-production assets) and the direct production costs of the output sold, as calculated from the avoidable cost curve.19 Included in the firm’s payment commitments will be the following: Non-production employee wages and salaries Plant overhead and maintenance costs (rent, electricity, gas, water, vehicles, etc.) Property and income taxes, permits, fees, etc. Interest and principal payments
16
Recall (from Chap. 5) that avoidable cost in this context refers to the cost of all inputs that vary with the rate at which a plant is operated, most of which will consist of materials and labor costs. Also, as in Chap. 5, if the firm has multiple plants of differing efficiency, it is assumed that the avoidable cost curve is constructed from left to right in terms of plants of decreasing efficiency. 17 Pretty much the standard terminology, after Hicks (1972), for these two types of markets is fixprice and flex-price. 18 Cf., Minsky (2008, p. 179). 19 Minsky, in his various writings, usually refers to quasi-rents as here defined as gross profits (or often simply as profits).
Fig. 15.3 Price-output conditions consistent with hedge finance
191 Price
15.4 The Many Burdens of Quasi-Rents
Hedge Finance R
K0
R
Avoidable Cost Curve
Output
Advertising and other marketing expenses Dividends If market conditions allow the firm to operate at a price–output combination that lies above the curve RR, it can be said to be safely engaged, at least for the current period, in hedge finance. However, if market conditions do not allow such a price–output combination (i.e., one that is above the RR curve), then the firm will find itself in a situation of either speculative or Ponzi finance – speculative finance if it can make up the shortfall between current cash flow and payments through the sale of assets, and Ponzi finance if the firm’s only recourse for covering the deficit is to borrow. The payment commitments in the list represent the many burdens that the cash flows from quasi-rents are made to carry.20 Dividends need not be paid – and income taxes if there is no profit – but interest and principal do, as do property taxes, and most (if not all) of the other items in the list. Whether or not the firm can meet its contractual payment obligations through cash flows from operations depends upon the conditions of demand facing its product. If the firm sells in a fix-price (i.e., competitive) market, then it may be at the mercy of the general economy (or possibly its misplaced expectations). On the other hand, if the firm sells in a flex-price market (i.e., faces a downward-sloping demand curve), so that it has some choice over price, its cash flows are somewhat under its own control. Yet, whatever the conditions of demand, cash flows are forever at the mercy of uncertainty, in that today’s demand conditions can be very different than what were assumed would be the case at the points in the past when today’s payment commitments were contracted. This is why prudent borrowers and their lenders – i.e., those engaged in hedge finance – should always (but not necessarily will) provide for healthy margins of error. In view of the burdens that quasi-rents are forced to carry, it is clear that the unit selling price of a firm’s output has to involve a markup over the average direct 20 An advantage of this way at looking at the burdens of quasi-rents is that, for firms with market power in their product markets (i.e., face demand curves with at least some downward slope), it allows for income taxes to be viewed as input into pricing decisions, as opposed to their incorporation into present-value calculations [as in the manner of Jorgenson (1996) and his followers].
192
15 Background and Tools for Understanding and Dealing with Recurrent Financial Crises
(i.e., avoidable) costs of production. Moreover, it is evident that the size of the markup will depend upon: 1. 2. 3. 4.
The proportion of non-production workers in the firm’s total employment The amount of taxes (whether property or income) that the firm has to pay The proportion of the firm’s investment that is financed through borrowing The volume of marketing costs (advertising, etc.) that is necessary for the firm to sell its output
With the markup over direct costs depending upon these factors, firms obviously have incentive to have (or to acquire) as much market power as possible in order to be able to exercise at least some control over their markups and, thereby, over their quasi-rents. This will especially be the case for firms operating in industries in which non-production workers (and other types of overhead) form a significant portion of total cost. On the other side of the coin, firms operating in highly competitive (i.e., fix-price) industries clearly do not wish to be saddled with flat or mildly rising avoidable cost curves, for quasi-rents in this situation are extremely vulnerable to changes in market conditions.21 From the foregoing, it is clear that firms’ primary concern with regard to pricing is to generate sufficient quasi-rents to validate (to use Minsky’s term) the payment commitments arising from past investment and spending decisions. For if a firm is to remain financially viable, then all of the contractual payments arising from the liability side of the firm’s balance sheet have to be validated. Inter alia, this includes all taxes (including income taxes) and makes clear that the widely held belief that corporations pay income taxes is mistaken. Corporations may collect a tax, but, if they are to remain financially viable, then either their customers (through higher prices) or their workers (through lower wages) are the ones that actually bear the burden of payment.22
21 Firms in the airline industry are especially fragile in this regard, for, in the short run, most costs are fixed, and what avoidable costs there are tend to increase only gently with utilization. Hence, competition that drives prices toward marginal avoidable cost often leaves insufficient revenues to cover the fixed costs. Essentially the only market power that most airlines have is to price seats non-linearly in the very short run, so as to extract as much consumer surplus as possible according to individual passengers’ willingnesses-to-pay. 22 This way of addressing firms’ pricing decisions yields yet another useful observation. Since a firm facing contractual payment commitments has strong incentives to cut costs, this occurs in many cases by transferring a good part of direct production costs off-shore (i.e., through outsourcing). The extreme, of course, is where production is totally off-shore, with output coming back into the country as imports. In this case, the unit cost of output becomes a fixed cost that has to be covered by price in the same way as any other non-production-varying cost. While total costs are obviously decreased by this process, prices will almost certainly be reduced less in flex-price markets than in fix-price markets. A second consequence relates to the impact on the distribution of income. Many of the jobs that are lost in an outsourcing will be high-wage blue-collar jobs that those laid off cannot find elsewhere, with the result that, for them, the only alternative is a lowerwage job in a service industry. On the other hand, some (though obviously not all) of the production jobs lost in the outsourcing will be offset through the hiring of new non-production workers, some of which will be at a lower wage than for the blue-collar jobs lost and some at a much higher wage. In either case, the result will be a worsening of the distribution of income.
15.5 The Banking Principle, Banking Disease, and Financial Panics
15.5
193
The Banking Principle, Banking Disease, and Financial Panics
Question: What do the following scenarios have in common: 1. The thirst of a large herd of cattle is serviced by a tank that holds, at most, 10 gallons of water and is fed by a pipe that replenishes the water at the rate of two gallons a minute. 2. An office with 100 employees, each with their own (fixed line) telephone, is accommodated by a single trunk line to the local telephone company’s central office that can handle at most ten calls at the same time. 3. A mutual fund has 50 million dollars under management, but only one million dollars in cash in reserve, which allows any of its 10,000 clients to withdraw their funds without notice. 4. A bank has 10 million dollars in demand deposits, but 100 million dollars in loans based on those deposits. The answer, obviously, is what was first encountered in the Prologue when G found that he could make loans from the bread trusted to him, and thereby could create claims that were in excess of the amount that was actually in existence. The reason that he could do this was that most of the time the ebb and flow of bread from his safe was in balance and was only a small proportion of the total in storage. He simply kept this amount of bread, plus a small additional amount as a margin for contingencies, and loaned out the rest. The same principle is in operation in all four of the scenarios: A small of amount of flowing water can keep a large herd of cattle from thirst, a small trunk line will allow any large number of individual lines to receive a dial tone with extremely high probability, a mutual fund can operate in normal times with a small reserve of cash, and a bank can support a large loan position from a small deposit base. All of these work because only a small proportion of the potential demand in each case becomes operative at any moment. While this powerful principle, what we shall call the Banking Principle, works smoothly most of the time, there are times when it obviously does not, namely, when a significantly larger than a normal number of potential demanders want the same thing at the same time. If the herd of cattle should be without water for several hours, all will be thirsty, and the tank and 2-gallon per minute inflow will be overwhelmed, with the result that there will be nothing but milling and bellowing chaos. Similarly, if everyone with a telephone should reach for it at the same instant, the system will seize up and no one will get a dial tone, and similarly for “runs” on the reserves of the mutual fund and bank. Thus, institutions and entities that function on a banking principle are highly vulnerable to events that can transform tranquility into chaos, a vulnerability that will be referred to as the Banking Disease. When one actually considers it, it is amazing how much of a modern economy is organized on the banking principle, for it allows for a few to service many, and
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thereby to economize on scarcity.23 And in most situations in which the principle operates, lapses into disease result primarily in inconvenience and inefficient use of time, rather than loss of trust or money. In these instances, breakdowns of the banking principle are almost always self-correcting, often through nothing more than mere passage of time. In money and finance, however, the situation is very different. For the banking principle, which is so powerful in organizing the transfer of purchasing power from those who save to those who invest, is also powerfully susceptible to the banking disease. The reason: money and uncertainty. Money, as has been emphasized throughout this volume, derives from trust and confidence, that confidence in whatever is functioning as money is indeed universal purchasing power. However, when banks and financial institutions enter the picture, another layer of trust and confidence comes into play, namely, that those who entrust money to such entities do so with a confidence that their money is both safe and available when needed. The reason that financial institutions are so susceptible to disease is that, virtually without exception, there is a serious mismatch between the duration of their liabilities and their assets, in that they borrow short, but lend long. This mismatch is obviously most acute with commercial banks, whose principal liabilities are deposits that can disappear in an instant, but whose bulk of assets are illiquid dated loans. In “normal” times, the banking principle operates sufficiently smoothly for financial entities that the ebb and flow in their short-term liabilities is easily managed with just a small amount of ready cash at hand. However, the problem with such institutions is that the short duration of their liabilities puts them in great peril regarding uncertainty. Anything that causes uncertainty to increase causes the liquidity premium of money to increase. Holders of non-money financial assets can rush to convert to cash, mutual funds can face demands for withdrawals, which (once cash reserves are exhausted) can only be accommodated by liquidation of positions, and commercial banks, though (because of deposit insurance) they no longer face the prospect of serious deposit withdrawal, nevertheless (as a result of the impact of the increased uncertainty on the balance sheet of their debtors) can feel a need to become more liquid. The extreme, of course, is a complete collapse and meltdown of trust and confidence, as during the fall of 2008, when the desire to hold money is nearly absolute, and markets for many financial assets, which in normal circumstances have two sides, possess only sellers. Financial panics are always accompanied by a collapse of confidence and increase in uncertainty, and always entail a rush to the safety of money. This is both the strength and weakness of money. For money, by being money, is perfectly liquid, but it is this perfect liquidity, as emphasized by Keynes in Chaps. 12 and 17 of the General Theory (and again in his 1937 QJE rebuttal of Viner), that – because it provides a safe haven in circumstances in which there may be no basis whatsoever
23
A few additional examples of this principle in operation include exits from theaters, ATM machines, and even public restrooms!
15.6 Types of Investors
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for assessing the future – can cause investment in new productive assets to grind virtually to a halt. Since a collapse in investment is what ultimately causes recession and unemployment, it is useful to remind ourselves just how (and why) it is that uncertainty in conjunction with the liquidity premium of money brings this about. To do this, we need to return once again to Keynes’s little understood discussion in the General Theory of own-rates of interest, and why it is that the own-rate of interest on money “rules the roost.” As was described in Chap. 4, the return to an asset consists of the sum of three factors, q c þ l, where q denotes a yield or net output, c denotes a wastage or carrying cost, and l denotes a liquidity premium. Capital assets, as noted in Chap. 4, possess these three factors in differing degrees. Money held as an asset has no yield (q ¼ 0), negligible carrying cost (c 0), but substantial liquidity premium (because it can be converted to money as a medium of exchange instantaneously without cost). Real assets have both yields (though for some, like Old Masters, these may only be psychic) and carrying costs, but in general little liquidity. Moreover, investment in real assets (because of decreasing marginal physical productivity and increasing borrower and lender’s risk) generally leads to declining yields. Since the liquidity premium for money dominates the liquidity premium for any other asset, this liquidity premium sets a floor to returns, which is to say that no investment will be pursued past the point where its yield falls below the liquidity premium of money. A sharp increase in uncertainty will substantially raise this floor, and thereby lead to a possibly precipitous decrease of investment in new productive capacity.
15.6
Types of Investors
In Keynes’s famous Chap. 12 of the General Theory in which he discusses the state of long-term expectation, he makes a distinction between enterprise and speculation. Specifically, Keynes defined enterprise as “the activity of forecasting the prospective yield of assets over their whole life” and speculation as “the activity of forecasting the psychology of the market.” For present purposes, it will be useful to further delineate two forms of speculation. The term speculation will now be taken as referring to as the taking of position in an asset on the basis of a belief that the current price of the asset is wrong in terms of its underlying economic fundamentals, while the term wagering will be taken as referring to the taking of a position in an asset on the basis of a belief that the conventional basis for valuing the asset today is not what it will be tomorrow.24 Thus, for the discussion to follow,
24 The two terms are intended to distinguish between those whose activities tend to make markets more efficient (speculators) and those whose motivation is to outwit the expectations of existing conventional bases (wagers).
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three different types of investors will be assumed to be involved in asset markets, namely, ones engaged in enterprise, speculation, and sheer wagering.
15.7
Differences Between Goods Markets and Asset Markets
A frequently overlooked fact is that an economy has what in effect are two aggregate markets, a goods market and an assets market. In the goods markets, flows are priced, while in most asset markets, it is stocks that are priced. The distinction is important, for while an increase in price leads to an increase in quantity supplied in a goods market, this is not possible in an asset market in which the stock is fixed. An increase in demand in this case (i.e., an increase in the willingness-to-pay to hold the stock) can often lead to an even further upward shift in willingness-to-pay, which will lead to a still further increase in price, and so on and so forth.25 While the stock of assets is fixed in the short-run, one might think that an increase in willingness-to-pay to hold the stock would set processes in motion that would lead to increase in the stock, and thereby to a dampening of the initial price increase. For productive-capacity markets, this will (as we have seen) in fact be the case, that is, a spot price that is greater than the supply price of new capacity will indeed lead to new investment (with the proviso, of course, that the investment can be financed). For assets like bonds, equity shares, and commodities, however, this is not necessarily the case, for an increase in price, occasioned (say) by position-taking motivated by enterprise or speculation is likely to catch the attention of gamblers motivated only by the prospect that the price will be higher tomorrow than it is today. Although in time supply in these circumstances can increase, the delay in response can be considerable, thus providing for what may be an ample interval for bubbles to form. Much will be said about this in the next chapter. A second important difference between the goods and asset market is that, whereas goods prices define values for current use, asset prices represent expectations of future cash flows (and therefore of future uses). Since asset markets entail the unknown (and unknowable), they are obviously much more affected (per the discussion in Sect. 1) by uncertainty than is the case in goods markets, indeed so much so that prices in asset markets (as noted by Keynes in one of his most oftquoted passages) are often determined largely by speculation and gambling.26 Prices in goods markets are determined primarily by businesses purchasing inputs into production and households purchasing goods for final consumption. Speculation and gambling obviously have little role to play. In asset markets, enterprise has a difficult 25
Put another way, a rising asset market is bumptious, and draws attention to itself. “Speculators [our wagers] may do no harm as bubbles on a steady stream of enterprise. But the position is changed seriously when enterprise becomes the bubble on a whirlwind of speculation. When the capital development of a country becomes a by-product of the activities of casino, the job is likely to be ill-done.” (Keynes, General Theory, p. 159) 26
15.8 The Floor for Asset Values
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row to hoe, for uncertainty can shift conventional bases for evaluation at virtually the speed of light, with a consequence that gamblers can feel that their information, which may entail nothing more than flipping (a possibly biased) coin as to what tomorrow’s prices will be, is as good as any, and maybe better than most. In short, asset prices can move with no more a basis than feelings of euphoria and gloom on the part of some and of a “friendly shoe” (from the game of chemin de fer) by others.
15.8
The Floor for Asset Values
When a financial panic ensues and there is a rush to the safety of money, many (even most) financial markets cease to have two sides, with the result that asset prices plummet. The question that we now want to address is, how far might they fall? Or, put another way, is there a natural floor to the value of assets, not just financial assets, but assets in general? To answer this question, we need to recall two results from earlier chapters: (1) that the sum-total of asset values (i.e., aggregate wealth) of an economy is bounded by the pool of fluid capital evaluated at current prices and (2) that broad asset classes cannot increase in value faster than the natural rate of growth of the economy (or equivalently by more than the natural rate of interest). Since these are key propositions for the question at hand, some refreshing of memory may be useful. As for (1), recall that when saving occurs out of current income, the income not spent represents equal additions (in value) to both the claims- and goods-sides of the pool of fluid capital, so that any increase in the aggregate value of financial assets cannot be greater than the increase in the claims-side of the pool. Since this is true not only of current saving, but also for all past saving (the sum-total of which constitutes the totality of claims on the pool of fluid capital), it follows that the aggregate value of the assets cannot be greater than this total.27 Proposition (2) then follows essentially as a corollary. For, since the aggregate value of assets is bounded by the sum-total of claims on the pool of fluid capital, the rate of growth in the aggregate of asset values cannot accordingly be greater than the rate of 27
A simple example involving an economy with a firm, a commercial bank, an investment bank, and a saver will hopefully add clarity at this point. Assume (1) that the saver saves 100 dollars out of his/her current income, (2) that the firm undertakes to invest in new capacity at an expected cost of US $85, which (3) is financed by a loan of that amount from the commercial bank. Assume that both the construction period and the period of the loan is 1 year. The addition is completed, the firm then sells new equity shares in the firm to the investment bank for US $85 (which also had been borrowed from the commercial bank), which it uses to pay off its US $80 loan (plus interest of US $5) to the commercial bank. The investment bank then sells the new equity shares in the firm to the saver for US $95, which the saver pays for by drawing down his/her savings deposit at the commercial bank. The investment bank then uses the proceeds to pay off its loan of US $85 from the commercial bank (plus interest of US $2), thereby keeping US $8 as an underwriting fee. Question: What is the maximum that the saver could have paid (in the absence of any new money creation) for the new shares? Clearly, the most that could be paid would be US $100, which is the point being made in the text.
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growth of income. Because of equalization of yields, the same will be true as well for all broad classes of assets.28 In normal (i.e., non-panic) times, the apparent aggregate wealth of an economy, calculated as the sum-total of market values across all asset categories, is many multiples of the stock of fluid capital, which is a fiction, of course, as any attempt to liquefy it would cause the financial system to completely seize up. If such were to ensue, those with money would obviously continue to hold it (whether in safe demand deposits or as cash under the mattress), as would anyone (and everyone) able to unload their positions for money. Eventually, all the money in the economy available to hold as a store of value would be owned by those unwilling (because of liquidity preference) to part with it. Almost certainly, the amount of money in question would be less than the stock of fluid capital, so that any floor to asset values, based on the existing stock of money alone, would be too low. However, at this point, let us imagine that a lender-of-last-resort (LOLR) comes into the picture with the power to acquire an appropriate amount of non-money assets in exchange for money.What would be the appropriate amount? One way to define “appropriate” in this situation would be for the LOLR to conduct a sealed-bid auction in which holders of “nontoxic” (i.e., not in default) assets specify a minimum price, in terms of cents on the dollar, in exchange for which they would transfer ownership of assets to the LOLR. Since such assets are non-toxic, the bids should be direct indicators of individual liquidity preference (i.e., how much each bidder is willing-to-pay to acquire the safety of money). “Appropriate” would then be defined by having the process proceed up to the point where bids reach 100 cents on the dollar. At this point, everyone (given their liquidity preference) who wants to hold money would have it, and all non-toxic assets would once again be in the hands of willing holders. A floor to asset values would accordingly be established that (as given by the amount of money in existence) should more or less be equal to the stock of fluid capital.
15.9
Asset Prices in a Financial Panic: the Role of a Lender-of-Last-Resort
All financial panics entail a breach in trust and a rush to the safety of money as a store of value.29 This characteristic of money, as has been noted, is both its strength and weakness, its strength because it provides a safe haven in times of great uncertainty, but also its weakness, because in its absence, the kind of uncertainty 28
It might seem that, in view of standard capitalization procedures, the wealth of an economy would be calculated as the present value of the prospective stream of its National Income. However, for this to hold would require that there be some entity with both sufficient wherewithal and willingness-to-pay to purchase it at such a “price.” 29 Put another way, we ordinarily think of the value of money in terms of prices of goods and services. However, we must also think of the value of money in terms of the prices of assets (both real and financial), which connects money to liquidity preference.
15.9 Asset Prices in a Financial Panic: the Role of a Lender-of-Last-Resort
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that causes financial panics would not exist. In a barter economy, a widespread dumping of goods in favor of a privileged good simply could not happen, for there would not be a privileged good. If there were, the good in question would, in effect, already be functioning as money as a store of value. Why is it, then, that financial panics can only arise in an economy with money? The answer lies primarily in the fact that money provides an efficient mechanism for transferring the purchasing power of those who save to those who wish to spend (whether in the form of investment in new produced means of production or of consumption in excess of income). It will be recalled from the discussion in earlier chapters that income generated from production in effect provides “claim tickets” to that production and that the income received is in the form of money. In normal circumstances, money income will be deposited in the receiver’s bank in the form of a demand deposit. While initially some of the money in the account may be set aside as saving and transferred into a time or savings account paying interest, the rest will be kept as a demand deposit until it is needed for consumption spending. Banks, however, are profit-seeking institutions, and, like all financial intermediaries, essentially engage in a “carry” trade, in which they borrow at one interest rate and lend at a higher one.30 It is at this point that the Banking Principle described earlier comes into play, for deposits that one bank loses to other bank are for the most part regained by transfers in the other direction, so that only a small proportion of a bank’s deposit liabilities need to be maintained as reserves (whether in the form of vault cash or deposits at the central bank or other banks). The rest can (and, in general, will) be loaned out. Since loans almost always initially involve the creation of new demand deposits, and since demand deposits function as money, a small reserve base can consequently support a large deposit liability – Why? Because, as per the Banking Principle, not everyone will be “picking up their telephone for a dial tone at the same time.” In short, a small addition to the stock of fluid capital (in the form of saving out of the current flow of income) can support a much larger addition to the stock of money. However, with regard to financial panics and why they can occur, commercial banks are only part of the story, for there are many other types of financial institutions, some functioning as intermediaries for channeling funds from savers to (mostly) enterprise investors, and others more engaged in speculation and outright gambling. Like banks, many of these are subject to the Banking Disease, in that their liabilities are of a much shorter duration than their assets. To fix ideas, let us consider three stylized non-bank financial entities: a traditional insurance company and current-day mutual and hedge funds. The insurance company will be assumed to sell life insurance and policies related to fires and other Acts of God. The mutual fund will be assumed to invest its clients’ funds only in equity shares, while the hedge fund will be assumed to invest in any assets, financial or otherwise, 30
Banks are unique amongst financial intermediaries in that, while anyone, by penciling a promise to pay, can create a potential means of payment, banks’ liabilities are actually accepted as money. However, since banks not only operate according to the Banking Principle in pursuing profit, they are also subject, in times of financial distress, to the brutal devastation of the Banking Disease.
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that it chooses. The insurance company’s only source of funds (other than interest income) will be assumed to be policyholders’ premiums, which it invests in highgrade long-term bonds. It obviously maintains a reserve for claims, which it keeps in demand deposits and highly liquid short-term government debt. It also has a line of credit with its bank for use in case of emergencies. The only regular source of funds for the mutual fund is the monies given to it by its clients, against which it maintains a reserve consisting of cash and short-term government debt. Also, the mutual fund has, like the insurance company, an emergency line of credit with its bank. The hedge fund, however, not only has the funds contributed by its clients, but also borrows substantial sums both from banks and in the commercial paper market. Of the three entities, the insurance company is clearly the most conservative in its investment portfolio, in that it invests its clients’ money only in high-grade bonds. Also, being an insurance company, it takes care to limit conflagration risk by careful re-insuring with other insurance companies. While not as conservative as the insurance company, the mutual fund is still pretty conservative in its portfolio, in that it owns shares in a variety of different companies in different industries in order to achieve diversification. However, while this can smooth out losses in individual shares, it cannot insure against a severe drop in the overall equity market. The hedge fund, on the other hand, feels that it is faced with virtually no risk at all because all of its positions are hedged and invests in only highly liquid assets that can be sold should a large amount of cash unexpectedly be needed. As described, all three of the entities feel that they are properly positioned against risk, but what about uncertainty? For the insurance company, the biggest contingency that it faces is that of conflagration – all its insured dying in the same short interval of time or all of its insured property being burned or destroyed concurrently. Mortality tables strongly argue against the former, while re-insurance with other insurance companies (unless they are all equally affected) effectively deals with the latter. The only real conflagration risk facing the insurance company would be were a substantial number of the companies whose bonds it owns to become bankrupt at the same time, thereby causing a precipitous drop in the value of its portfolio. But, all considered, traditional insurance companies, because of the nature of the businesses that they are in, should be able to ride out financial panics with relative ease. The mutual fund, on the other hand, faces a much greater exposure to uncertainty, in that it is subject to a run by its clients on its reserves, which may only be replenished through liquidation of its share holdings in a sharply falling market. As for the hedge fund, while it may have normal risks hedged away, the fact that its positions are heavily financed by short-term borrowing makes it extremely vulnerable to uncertainty and financial panics, as witness the demise of the LongTerm Capital Management Fund in 1998 and the events associated with the financial tsunami of 2007–2008. When a panic ensues, the hedge fund can face a double whammy as its “wagers” go wrong and it is unable to roll over its debt at banks or renew its commercial paper, as occurred in the fall of 2008.
15.10 The Effect of Financial Panics on the Real Economy and the Role of Fiscal Policy
201
A useful way of viewing uncertainty is as a spirit that (like confidence) permeates all psyches.31 At times, as during a prolonged boom (or, similarly, during a prolonged period of gloom), the conventional basis governing it can appear very stable, but at other times can shift and change for no apparent reason as a bolt out of the blue. All financial panics are caused by a change in basis of some form or another, at times maybe in a single market brought about by a collapse of confidence in a single firm, while at other times the cause may be a universal shift that affects everyone. Whatever, a panic sets forth a rush for the safety of money. Money, however, is scarce, and the amount in existence may not be sufficient to satisfy the demand. In this situation, the only way of thwarting the panic is for a LOLR, as exemplified in a central bank, to be available. When the public fleeing a panic demands money as a store of value, the task of this lender (indeed, its only task in the situation) is to provide it.32 There are a variety of ways that a central bank can (and does) satisfy a financial panic’s thirst for liquidity, including the standard ones of providing reserves to the banking system through open-market purchases of government debt and making loans through the discount window. However, as in the financial meltdown of the fall of 2008, these channels may not be enough, and the LOLR may be forced to monetize other forms of private debt, whether through guarantees or outright purchase. Thus, in the collapse of 2008, we have seen the Federal Reserve (or the Federal Deposit Insurance Corporation) “insure” commercial paper and deposits in money-market funds and prepare to purchase not only long-term government bonds (which would be the equivalent of printing money directly), but also the high-grade senior debt of private corporations. More directly, public funds have been used to inject money into the balance sheets of capital-depleted banks and to provide both guarantees and collateral for the loan-default policies written by the American International Group (AIG), which had ceased to insure against just Acts of God, but also against the possibility that issuers of private debt would default on their loans.
15.10
The Effect of Financial Panics on the Real Economy and the Role of Fiscal Policy
While financial panics do not always send the economy into a downturn, really severe panics almost invariably do. Specifically, a collapse of confidence impacts the general economy through two uncertainty-laden channels. The first is through 31 To attempt to visualize uncertainty is a bit like the remark of the great theoretical physicist Paul Dirac concerning quantum mechanics: “To draw its picture is like a blind man sensing a snowflake. One touch, and it’s gone.” (Farmelo 2009, p. 146) 32 The words of Bagehot (1873, p. 24) come to mind at this point that, in times of financial crisis, money should be freely available, but at a penalty rate. While Bagehot was obviously focused on the circumstances of his time, the admonition to lend at a penalty rate also makes sense in modernday panics because of the strong incentive it provides for excessive liquidity to be removed once a crisis passes.
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liquidity preference raising the rate of interest, and thereby impacting investment, while the second is through uncertainty increasing the propensity to save, and thereby reducing the amount consumed out of a given level of income. Increased liquidity preference accompanying a collapse of confidence adversely affects investment in two ways: (1) through an increase in the rate used to discount quasi-rents and (2) through decreased expectations of the quasi-rents themselves. Finally, uncertainty having a positive effect on the propensity to save is essentially an expression of increased fear of the unknown on the part of households.33 The standard (Keynesian) response to recession, whatever its cause, is for fiscal policy to take up the slack in aggregate demand caused by reductions in investment and consumption. An output “gap” is estimated, from which a needed fiscal stimulus is estimated employing an appropriate government-expenditure multiplier. While this is Keynesian textbook stuff, the problem is that, multipliers tend to be anything but stable, which, together with legislative vagaries, hardly leaves contra-cyclical fiscal policy a scientific pursuit. This problem aside, a question that is usually not asked in conventional macroeconomic analysis is: How large should the public sector be in order to provide a plausible cushion against unpredictable swings in investment (and, to a lesser extent, swings in the marginal propensity to save)?34 The answer to this question is simple, and involves nothing more than consideration of the GDP identity (ignoring exports and imports): GDP ¼ C þ I þ G, where the symbols have their usual definitions. Taking investment (that is, I) as the most volatile of the components of GDP, then if G is to provide a buffer against changes in I, it is clear that the two must be more or less of the same magnitude. In 2007, total private investment spending in the USA was US $2.1 trillion, while total government spending was US $2.4 trillion.35 While this might seem a more than sufficient amount, it has to be kept in mind that federal spending (including transfers to state and local governments), which is the government spending that is relevant for contra-cyclical fiscal activity, was about US $1.4 trillion.36 Thus, if the federal budget is to act as counterweight to swings in private investment, a shortfall of 10% in private investment would have to be offset by about a 15% increase in federal spending. Obviously, the larger federal spending
33
It should be emphasized that the reference here is to the effect of a collapse of confidence on the entire consumption function, not movement along a given consumption function caused by changes in income. The sharp increase in the US personal saving rate in late 2008 and early 2009 is a case in point. 34 See Minsky (2008, Chap. 13, pp. 330–343). 35 All data are from the Economic Report of the President (2009). 36 This “shortfall” of US $700 billion in federal spending vis-a`-vis private investment for 2007 puts an interesting perspective on the US $787 billion “stimulus” package passed by the US Congress in early 2009.
15.11 Conclusion
203
is as a proportion of GDP, the easier it is for the federal budget to be used as a fiscal stabilizer.37
15.11
Conclusion
The purpose of this chapter has been to develop background and notions that will be useful in the next chapter in interpreting and analyzing financial panics and meltdowns of the type that occurred in the fall of 2008. The role that money plays in the face of uncertainty has been center-stage, as has also the importance of unpredictable changes in the conventional basis of valuation in determining the pace of investment. The fact that investment must be financed has been emphasized, as has the fact that the structures of asset markets differ significantly from those of goods markets. In goods markets, price declines attract buyers, whereas it is frequently the opposite in asset markets. Finally, it should be noted that the inspiration for much of this chapter derives from Keynes’s discussion of money and uncertainty in Chaps. 12 and 17 of the General Theory and his 1937 QJE rebuttal of Viner, almost all of which was shunted aside in the incarceration of the General Theory in the Neoclassical world of IS-LM. One must be grateful as well to the late Hyman Minsky for emphasizing the importance of these neglected ideas and keeping them before us.
37
This is not a political (or moral) argument for greater federal spending as a proportion of GDP, but rather just a statement of an arithmetical fact. The deficit-spending of the 1930s was unsuccessful in eliminating unemployment because it was simply not large enough in relation to the collapse in private investment.
Chapter 16
Booms, Busts, and Financial Panics: The Financial Meltdown of 2007–2009
In this chapter, we shall take a detailed look at what appears to be an increasing vulnerability of world economies to financial booms, busts, and panics, with emphasis on the financial meltdown of 2007–2009. However, in approaching this, it is important to keep in mind that there is nothing new per se about financial panics, for they have been part of economic life for as long as Society has been aware of the usefulness of money as a store of value.1 The one thing that every financial panic in history has shared is that there is a “tipping” of confidence into uncertainty that leads to a rush for the liquidity of money.
16.1
The Anatomy of Financial Panics
As a primer for the later discussion and analysis, it will be useful to narrate the genesis, denouement, and subsequent aftermath of a prototypical financial panic in a framework that, while stylized and simple, is sufficient to capture the key elements of today’s highly complex financial structures.
16.1.1
Emergence from Recession
Let us pick up an economy at the point of recovery from a recession.2 Financial wounds have been licked, unemployment has stabilized, banks have excess 1
The standard references to historical financial panics are Kindleberger (1978) and the classic of Charles Makay (1852). cf., as well, Bagehot (1873). Also, the USA has experienced four banking crises since 1980 [see article by J. Surowiecki in The New Yorker, April 6, 2009]. 2 The usual situation following a widespread financial panic is a period of communal melancholy in which uncertainty settles into collective gloom about the future and liquidity preference reigns supreme. The effect on the real economy during such periods can be devastating, as in the early years of the Great Depression and, to a lesser extent, following the financial meltdown of the late Summer and Fall of 2008. The communal gloom has to be dispelled before recovery can begin.
L.D. Taylor, Capital, Accumulation, and Money: An Integration of Capital, Growth, and Monetary Theory, DOI 10.1007/978-0-387-98169-7_16, # Springer ScienceþBusiness Media, LLC 2010
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reserves, inventories are lean, and there is sufficient optimism about the future that liquidity preference has loosened its near death-grip on money. Firms see sales starting to pick up and begin to foresee a need for additional capacity. However, with the recession fresh in mind (for managers and bankers alike), borrower and lender’s risk is high for any investment much beyond available internal funds. Consequently, despite low interest rates, investment in new capacity is constrained, not by present-value criteria, but by hesitant and balky finance. A pick-up ensues, but the pace is slow. Assume, now, that a couple of periods pass in which expectations are met and quasi-rents (i.e., cash flows) are sufficient to keep all stakeholders (bankers, bondholders, shareholders, and governments) happy. Things accordingly begin to loosen up. Both borrower and lender’s risk lessen, so that a larger share of the cost of new investment can be financed through borrowing. But while loans to firms increase, both firm managers and bankers are concerned that borrowing remains safely in the category of hedge finance. At this stage, the economy would seem to be entering a period of stable economic growth. Profits are positive, employment is increasing, as is also productivity (because of newly produced means of production coming on stream), which results in increasing income and therefore spending and saving. This virtuous circle of saving, investment, and productivity increases keeps goods prices stable, so that the central bank sees no need to brake the growth in bank reserves.
16.1.2
Awakening of Asset Markets
As the economy continues its recovery, the stock market, though recovered from recession lows, bounces around in a narrow trading range. However, the fact that firms (and banks) are turning profits begins to be noticed, which causes some investors to begin moving their holdings from cash and low-interest money-market funds into stocks, which (since, in the short run, the supply of shares is a vertical spike) cause share prices to begin a steady increase. These increases attract the attention of still other investors, whose purchases in turn cause prices to increase even more.3 All of this is good news for firms, for, as with the lessening of borrower
3 Here is a good place to once again point out a myth and falsehood, namely, the view that an increase in share prices, ceteris paribus, represents a like increase in wealth. While the agents selling shares have an increase in their personal wealth, this is not the case for the economy as a whole, for the transactions involve nothing more than exchanges of existing assets (money for shares, and vice versa). The only wealth that is created is represented by the income generated in brokerage/middlemen fees. For a rare instance of a financial writer’s appreciation of this truism, see Buttonwood, “The Nature of Wealth,” in the October 10th–16th, 2009, issue of The Economist, p. 76.
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and lender’s risk, the increase in share prices provides an important new way of financing expansion, namely, through issuance of additional shares of equity.4 With several periods of expectations being met, increasing employment and income, and rising asset prices, the mood of the economy increasingly becomes one of confidence and optimism, that tomorrow is going to be better than today. The central bank, with its focus on the prices of goods and services, sees little danger of inflation (in substantial part because of a seemingly endless supply of low-cost imported goods) and accordingly keeps short-term interest rates low. With employment high, investment strong, low inflation, low interest rates, and rosy prospects of continued growth, the economy seems poised to enter a fabled age of wealth creation.
16.1.3
Some Signs of Danger
Nevertheless, all is not well, for the stage is being set for trouble in the asset markets. In the early part of an economic recovery, increases in asset values are fueled mainly by shifts from demand and savings accounts, money-market funds, and sale of short-term government securities, shifts that, for the most part, reflect actions in response to increased confidence and lessened liquidity preference. As the economy grows, asset values may, at least for a while, continue to increase simply in line with saving out of increased income that enlarges the underlying pool of fluid capital. While this is exactly as it should be, rising asset prices unfortunately also have a downside, for they almost inevitably attract the attention of investors whose motivation, rather than enterprise, is speculation and wagering. The potential 4
As put by Keynes in the General Theory (pp. 150–151): Decisions to invest in private business of the old-fashioned type were, however, decisions largely irrevocable, not only for the community as a whole, but also for the individual. With the separation between ownership and management which prevails today and with the development of organized investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to instability of the system. In the absence of security markets, there is no object in frequently attempting to revalue an investment to which we are committed. But the Stock Exchange revalues many investments every day and the revaluations give a frequent opportunity to the individual (but not to the community as a whole) to revise his commitments. It is as though a farmer, having tapped his barometer after breakfast, could decide to remove his capital from the farming business between 10 and 11 in the morning and reconsider whether he should return to it later in the week. But the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes in investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.
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for trouble is not serious if speculators and gamblers use only their own money, but is an entirely different matter when asset purchases are financed through credit creation and borrowing. When this happens, asset values are no longer anchored in the constraints imposed by the underlying pool of fluid capital, but rather are determined by the expectations of tomorrow’s prices in relation to today’s. Prospective yields of “investment” cease being quasi-rents down the road, but the lure of immediate capital gains. In short, to paraphrase Keynes, asset markets have become casinos.
16.1.4
Casinos with Banks
However, there is one important difference between asset markets functioning as casinos and actual casinos: One cannot stop at a bank before entering an actual casino for a loan to finance play; casinos might provide short-term credit to some of their players, but collection in the event of bad luck can be insistent and unpleasant. In asset markets, on the other hand, hedge funds and the trading desks of investment banks, brokerage houses, and insurance companies (and even of commercial banks themselves) all trade with borrowed funds, much of which is obtained from banks. When assets are purchased with newly created money, their prices (as just noted) are disconnected from the constraints imposed by the pool of fluid capital. If such new money were to find its way (as, say, through the sale of new equity) into investment in new produced means of production, the disconnect would be short run, for the capital market in this case would be working in one of the ways that it should. On the other hand, if money created for speculation and wagering should remain in the financial circulation (to borrow a term from Keynes’s Treatise on Money), then the disconnect from the pool of fluid capital would be complete. But, why should prudently managed banks that would never consider underwriting gambling activity in real casinos be willing to do so in asset markets? A bank would never be willing to finance casino gamblers because the expected return, no matter how many loans might be involved, is obviously negative. A loan to a hedge fund or the trading desk of a bond house, however, would seem to be different. For, with rising asset prices, trading profits are apparent everywhere, so risk, especially on very short-term collateralized loans, would appear to be small. Thus, loans are made, repaid with interest, and then extended again, but this time, since asset prices are now almost certainly higher, for a larger amount, and so on and so forth. The process feeds on itself, and seemingly with no increase in risk.
16.1.5
Getting Ready for a Fall
At this point, asset prices are unhooked from underlying real factors (specifically, increases in the pool of fluid capital and capacities to produce) and instead are fueled by borrowing and creation of credit. The question now becomes, how far/how long can the process continue? There are really two components to this question: why? and
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when? Why is in principle answerable, but when is not. To see that this is the case, let us first look as to why an asset inflation will eventually come to an end. In any asset market in which exchange occurs, every transaction necessarily involves a willing buyer and a willing seller, which means that there has to be a diversity of expectations with regard to the price of the asset tomorrow. In particular, the buyer has to have an expectation that the price tomorrow is going to be higher than that of the seller. If expectations are reasonably continuous and distributed evenly around (i.e., both above and below) the present price, then a desire (for whatever reason) on the part of someone to change their position will find a willing complement with little effect on price. However, if something should happen to cause an upward shift in the conventional basis for evaluation, the market price will rise accordingly.5 Per the assumption in this narrative, this rise draws speculators/wagerers into the market with bids sufficiently high to cause some that had previously been “bulls” to become “bears” (to use the terms first coined by Keynes in the Treatise on Money). As “bears” exit the market, expectations become more and more concentrated around the existing price, at which stage the market will be extremely vulnerable to any change in sentiment in a downward direction. Inevitably, this will happen, for with expectations “spiked” at the current price, even one “bull” (for whatever reason, perhaps nothing more than a random firing of neurons) becoming a “bear” can cause a stampede to sell.6 And, as everyone is now a “bear,” there will be no buyers.7 Thus, the why of an upward speculative/wagering process in an asset market eventually coming to an end is clear and answerable. For expectations will eventually spike on the current price, and anything – perhaps no more than a rumor – that
5 If everyone’s expectations are affected proportionately, the price rise could occur in the absence of any transactions. 6 Just as a lack of genetic diversity within a species can lead to the species becoming extinct, so, too, can a lack of diversity (in this case, of expectations) cause a market to implode. [cf., Samuelson (1992) and Keynes (1936, p. 172).] Moreover, if the “bears” exiting the market genuinely “take their money and run,” liquidity is thereby reduced. 7 An alternative scenario leading to asset-price crash is as follows. Assume (1) that we have an asset market with n existing shares and N participants, n N; (2) that the willingness-to-pay (WTP) per share of the asset is distributed uniformly between PL and PU (both of which are variable) across participants; (3) that the market is organized only to the extent that the price of each trade is posted for all participants to see; (4) that upon a sequence of three consecutive prices (which is assumed to occur at random), each of which is higher than its predecessor, each additional price increase leads to speculators/wagerers entering the market with WTPs that are higher than the last posted price. Trades in the market will be assumed to occur by chance meetings of agent-holders of the asset with agents having higher WTPs. In these circumstances, three consecutive trades with increasing prices will with non-zero probability eventually occur, which catches the attention of speculators/wagerers. As these come into the market, posted prices will begin an upward trend that will continue until such time that the set of potential speculators/wagerers runs dry. At this point, the agents in the market with WTPs greater than the last posted price will also run dry, which is to say that virtually everyone still in the market will be a bear. The market will be at a peak, and accordingly extremely vulnerable to a downturn and crash.
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causes even a minor shift in sentiment can lead to a panic to sell. However, the when of this happening is genuinely uncertain, and therefore not predictable.8
16.1.6
Onset of a Panic
Speculation/wagering getting out of hand is probably easiest to describe in financial markets, but real markets can become “casinos with banks” as well, as witness the bubble in residential housing in the USA, UK, Spain, and other countries in the several years preceding the financial meltdown of 2007–2009. All that is needed is for some initial price increases to take place that catch the attention of speculators/wagerers, and then the latter being able to convince banks and other lenders to finance their activities. The dynamics are then the same as in financial markets, and with the same end result.
16.2
The Fragility of Financial Markets
As just noted, once expectations become concentrated at the current price in an asset market, the stage is set for even a slight downward shift in sentiment to cause a wholesale desire to sell. Why is this? Why is an asset market so vulnerable to implosion at this point? The reason is that the “bull run-up” in price has effectively eliminated diversity in expectations, with the result that present holders of the asset are essentially identical both in their outlook and, even more importantly, in the way that they react to and process new information. This makes for a very fragile basis for valuation, for if one speculator/wagerer should change his/her outlook, others are almost sure to follow. One holder may be able to find “a greater fool,” but almost certainly not two. Once sell orders appear with no offsetting offers to buy, the asset price will obviously plummet, and will do so until some factor emerges to provide a floor. What this factor will be will depend upon both the market involved and the overall state of confidence. If the market in question is small in relation to the other asset markets, and overall confidence is not affected, the panic should eventually be arrested by a return to the market of enterprise investors at a level consistent with the underlying pool of fluid capital. On the other hand, if the panic should (for whatever reason) unloose a wave of uncertainty that spreads into other markets, there could be an evaporation of confidence, and a resulting stampede for the safety of money. A second factor making for fragility in asset markets is the multiplicity, both horizontal and vertical, of financial intermediaries that populate modern economies – horizontal in that there are many financial entities of the same type and vertical in that 8
Yet, this is not to say, as will be pointed out below, that certain signs of impending panic do not present themselves.
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there are many types. While one ordinarily thinks that large numbers and diversity make for stability, this is not the case in finance. The reason for this is as follows. To begin with, all financial intermediaries engage in “carry” in some form or another, in that their profits depend upon the difference between the rates at which they can borrow and the rates at which they lend. This, accordingly, makes intermediaries sensitive to anything that affects their “spread” (that is, the difference between their borrowing and lending rates). Moreover, in most instances, their borrowing is much shorter-term than their lending, which makes them doubly sensitive to the spread, or, in technical terms, to the slope of the yield curve. Anything that either flattens the yield curve or causes hesitancy on the part of short-term lenders to lend is therefore obviously of concern. Accordingly, in order to avoid being caught short, all financial intermediaries have to maintain an appropriate buffer of liquidity, at least part of which is in the form of money. Money, however, is scarce, and at any point in time the amount that is available to be held as an asset has the task of protecting the financial structure against the bogeyman of uncertainty. Consequently, as the number of financial intermediaries increases, the reserve stock of money becomes stretched ever more thinly, making the financial system increasingly vulnerable to any stumbling of confidence. A third factor making for fragility in asset markets is the lessening of borrower and lender’s risk that attends good times. Hedge finance becomes speculative finance as firms become more sanguine about the future and lenders seek higher returns. Caution is thrown to the wind in asset markets that are seemingly reaching for the sky, and innovative investment strategies designed to spread and reduce risk come into play by entities engaged in speculation and wagering. Accompanying an increased tolerance for risk is a strong motivation to make money held in reserve more efficient. There are two ways that this is done. The first way, in keeping with decreased risk-aversion, is simply to reduce the cash held as a ratio of liabilities, whether directly or indirectly through the holding of short-term marketable securities. The second way, which is the sine qua non of hedge funds and the trading desks of commercial and investment banks (and now increasingly insurance companies), is through hedging and the purchase of credit insurance, both of which are designed to lessen risk and therefore reduce the amount of money held in relation to liabilities. However, while such activity can reduce the risk for any one entity, it can actually increase the vulnerability of the system as a whole to uncertainty. To see how and why this is, we need to distinguish between two different types of hedging. The first is that usually taught in economics and finance textbooks. A position in the spot market is offset by an opposite position in the futures market, in which case the risk of price movement is transferred to an entity willing, for a fee, to hold it. Enterprise is involved in at least one of the transactions, and perhaps even both. On the other hand, the type of hedging engaged in by hedge (and hedge-like) funds is generally of a very different variety, for the instruments exchanged (usually derivatives) are different and motivation is typically speculative or wagering. Profits depend upon underlying statistical models, which drive the bets, being “right,” which in turn depends upon covariances
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observed during the models’ periods of fit continuing to hold.9 However, with speculation and wagering, success breeds imitation, and secrets are hard to keep. Imitation can proceed to a point where much of the activity in the markets in question is driven by the same strategy, which is equivalent to a “spiking” of expectations as described above.10 As before, this makes participants extremely vulnerable to a change in the underlying basis (i.e., to a breakdown in the covariance structure). When such a change occurs, as will inevitably be the case (whether from within the markets in the grip of hedging or from spillover from other markets), there will again be a rush to liquidity. The seeming security of hedged investments is thus an illusion for the system as a whole.11 For, since none of the activity, except for brokerage and middlemen fees, adds to the pool of fluid capital, the result is that the stock of money serving as reserves is made to support more and larger layers (in effect, an inverted pyramid) of financial liabilities. The problem involved is as follows. Money as a medium of exchange is obviously independent of its origin, but this is not the case for money functioning as a refuge against uncertainty. The total stock of money in the financial circulation consists of money arising out of saving (and is therefore part of the claims side of the pool of fluid capital) and money that comes into being through bank loans extended to entities engaged in the buying and selling of financial instruments. The former is not subject to “call,” but the latter is, for the loans that created this money (which are typically of very short duration) must be repaid.12 Hedge funds and trading desks operating with such
9 Covariance enters into financial modeling in two different ways. The first refers to the covariation between (and amongst) variables forming a relation in the past that is assumed to hold in the future as well, such as, for example, the relation between yields of two different assets. The second use of covariance in financial analysis is in the bundling of assets, whether for purpose of diversification in the construction of portfolios of stocks or bonds or in the selection of group of assets to be securitized. “Proper” risk management requires that there be no positive covariances amongst the items bundled. In the bundling of home mortgages for securitization, for example, it was thought that, since there had been no nation-wide downturn in housing prices since the Great Depression, correlations of mortgage default across regions would be zero. This being the case, the default risk of a bundle of such mortgages would therefore be much smaller than the default risk of any individual mortgage in the bundle. A “slice” from a bundle of mortgages which were all individually rated BBB could accordingly have a rating of AAA, or so the bundlers were able to convince rating agencies would be the case. The conflagration risk of a national collapse of housing prices, as in fact happened beginning in 2007, was ignored. 10 The financial crisis associated with the collapse of the Long-Term-Capital-Management hedge fund in 1998 is such a case in point. For a background and analysis, see Bookstaber (2008). 11 Put another way, what cannot be hedged away is “conflagration” risk. While every financial entity might be perfectly hedged with regard to its creditors and debtors in isolation, it cannot be hedged against a firestorm of panic that overwhelms all. 12 This may seem an overly subtle distinction, but is fundamental to an understanding of why bank financing of speculative/wagering activity makes financial systems so vulnerable to changes in sentiment. The point is that, unlike for money that is created through current loans to financial entities, the money arising from current and past saving is no longer connected to the loans that created it, and is therefore not subject to annihilation.
16.3 A Digression on Uncertainty, Confidence, and Trust
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financing are thus analogous to a gambler wagering with money borrowed from a bank, rather than with his own. In normal conditions, loans of this type will be renewed (or even increased), so that overall liquidity is unaffected. However, anything that increases uncertainty will lead banks to draw in their horns. Loans will not be renewed, new lines of credit will not be extended, and existing lines will almost certainly be reduced. Hence, much of the money that had been “speculatively” created (i.e., the money that is subject to call) will cease to exist, with the result that the stock of “permanent” money (i.e., the money associated with the pool of fluid capital, and therefore not subject to annihilation via the repayment of loans) will become increasingly stretched as a cushion against uncertainty. In these circumstances, once a rush to liquidity (for whatever reason) should start, hedges as a group, no matter how “scientifically” they may have been devised, can do nothing to stem the rush, and indeed will probably exacerbate it.13
16.3
A Digression on Uncertainty, Confidence, and Trust
“Of all kinds of capital,” said Demosthenes, “the most productive in business is confidence, and if you do not know this, you do not know anything.”14
In Chap. 13, a list of conditions was presented that must be met if economic growth (defined as a sustained increased in income per capita) is to occur: 1. Economic growth requires investment in produced means of production. 2. Investment requires fluid capital for finance, which in turn requires saving, either out of current income or out of income at some point in the past. 3. Increased produced means of production provides the potential for economic growth. For the growth to be realized, the increased capacity to produce must be utilized and the increased output resulting therefrom must be purchased at compensatory prices. 4. Continued growth requires that this process be continually repeated. Each of these conditions is necessary for economic growth to occur; as a group, they are sufficient as well. While these conditions are formally correct as they stand, glossed over is an assumption that the finance necessary for investment to take place is actually forthcoming. However, as is emphasized in these postscript chapters, firms can propose, but in a capitalist monetary economy, once a firm’s internal funds are exhausted, it is the financial system that disposes. Whether or not
13 This is because the greater the number of entities engaged in hedging activity, the greater will be the number, in terms of probability (see Sect. 4 below), that can run out of reserves, which, in turn, can lead to the failure of others, and so on and so forth. 14 Quoted by Homer and Sylla (2005, p. 38).
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the needed finance is forthcoming depends upon three elusive intangible states: uncertainty, confidence, and trust. While it might be thought, in the present context, that confidence and trust are pretty much the flip-side of uncertainty (in the sense that presence of the former indicates absence of the latter), this is not the case. Uncertainty arises from the inherent unknownness of the future and is essentially ever present, while confidence and trust involve how this unknownness is approached in the making of decisions. Uncertainty is thus (at least in a sense) an objective feature of the real world.15 Confidence and trust, in contrast, entail how economic agents, both individually and en masse, react to and deal with uncertainty. In normal discourse, confidence and trust are usually treated as synonyms. The Oxford English Dictionary, for example, defines confidence as “the mental attitude of trusting in or relying on a person or thing,” while trust is defined as “confidence in or reliance on some quality or attribute of a person or thing, or the truth of a statement.” While these definitions might seem virtually circular, there is an important distinction, in that confidence refers to the mental attitude of the self, while the referent of trust is qualities or attributes of others. With this distinction in mind, it is useful for present purposes to view trust as assurance on the part of individuals in the integrity of a society’s institutions (both legal and social), that financial contracts will be executed in good faith and that a fiduciary’s word, whether of an individual or an institution, is its bond.16 Confidence, on the other hand, will be seen as a measure of the degree to which agents are willing to act upon trust. In the absence of trust, there can obviously be no confidence, yet confidence can be absent even when trust is present. An individual may have in the past often acted profitably upon the advice of a trusted financial advisor, but is now hesitant to accept (or rely upon) the advisor’s judgment – this, even though it is believed that the advisor is continuing to act in good faith. Another important difference between trust and confidence in the present context is that confidence tends to be collective in scope, while trust is individual, by which is meant that confidence, though obviously based within, is frequently a shared state (or mood), whereas trust is usually one-on-one. Confidence is infectious, can be everywhere, and then nowhere, while trust, except in times of panic, is much more stable and pretty much free of spillovers across individuals and markets.17 Both confidence and trust, once shattered, are slow to recover, but
15
As characterized by Skidelsky (2009, p 84): “Under capitalism, uncertainty is generated by the system itself, because it is an engine for accumulating capital goods whose rewards come not now but later. The engine of wealth creation is at the same time the source of economic and social instability.” 16 During the late Summer and Fall of 2008, the deterioration in trust between financial entities took the form, first, of one institution not accepting another’s IOUs without collateral and, then, refusals to extend credit no matter what the collateral. 17 It is to be emphasized that confidence is both interactive and shared – interactive in the sense that one’s person’s confidence can affect another’s, which in turn can feed back on the first’s confidence, etc., and shared in the sense of confidence being a spirit-like sentiment that envelops entire markets and even entire economies.
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confidence can ebb and flow, and even collapse, with little (if any) effect on trust. However, this is not to say that in the case of a widespread collapse of confidence, such as occurred in the Summer and Fall of 2008, there cannot be a collapse of trust as well. Nevertheless, trust is more fundamental than confidence, and if trust is dead, so too will be confidence.18 Much of the time financial markets are driven by the interaction of confidence and uncertainty, as two mass psychologies, with scant regard for underlying economic fundamentals. Several periods of fulfilled expectations can stoke confidence greatly and cause uncertainty (in terms of agents’ perceptions) to recede into the background and be treated as risk or even ignored altogether. The interaction between uncertainty and confidence is an obviously complex one, and probably best to say ill-understood. A certain amount of uncertainty is always present in economic activity because of the inherent unknownness of the future, but can increase or recede in perception as financial transactions move away from, or closer to, the security afforded by money, specifically, by that part of the stock of money that resides in the pool of fluid capital.19 Confidence, in contrast, is a force that pulsates through and across psyches, both individual and collective, and that buoys spirits and obscures uncertainty. Rising confidence decreases borrower and lender’s risk, which is fine for awhile, but (as we have seen) can eventually lead to debt creation that exceeds the rate of growth of real production, thereby leading to finance becoming increasingly speculative and Ponzi. In time, as well, distributions of expectations become increasingly concentrated, which makes confidence highly vulnerable to surprise and collapse. A collapse of confidence then leaves uncertainty bare and ugly, a collective fear sets in, liquidity preference surges, and there is a rush to the security of money, a rush that will be all the more destructive the more that debt creation during a confidence-induced boom exceeds the rate of growth of real output.
16.4
Preludes to Panic
As a boom builds, the financial system becomes increasingly vulnerable to a collapse in confidence and subsequent panic. The following factors contribute to this vulnerability. 18 Not only is trust more fundamental than confidence, but it is also more concrete. When an individual or institution wants to strike at the core of another, it is not said: “I/we lack confidence in you,” but rather, “I/we don’t trust you!” 19 As alluded to at the end of Sect. 2 above, there is an important distinction here to be noted. While a dollar is a dollar no matter what its origin, the stock of money at any point in time really consists of two parts, a “permanent” part which owes continued existence to current and past saving, and a “temporary” part that coexists with bank loans. The “permanent” component, since it is not subject to destruction through repayment of loans, represents an ultimate source of security against uncertainty. The “temporary” component, on the other hand, is available as a safe-haven against uncertainty only if the bank loans that created it are continually renewed (or else defaulted upon).
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16.4.1
16 Booms, Busts, and Financial Panics: The Financial Meltdown of 2007–2009
The Layering of Financial Intermediaries
A hallmark of modern monetary economies is both the number and layers of financial intermediaries. Where once commercial banks took deposits and made loans for financing current production, investment banks underwrote additions to productive capacity, and insurance companies offered protection against fire, death, and unfriendly seas, the lines separating these entities are now heavily blurred. Banks sell insurance, investment houses take deposits and make loans, and insurance companies purchase not only long-term financial assets but insure against their default. For the most part, however, what has just been noted is just the tip of the iceberg, as it reflects legislative and regulatory changes that have allowed the “old” players to invade one another’s traditional fiefdoms, and accordingly should not be confused with the “new” finance that has greatly multiplied the number of financial players and the products and services offered. New players include finance arms of industrial corporations (GE Capital, GMAC), money-market funds of banks and brokerage houses, trading desks at virtually every large bank, brokerage house, and insurance company, and a plethora of hedge funds (most of whose purpose is not investment in the traditional sense, but the devising of low-risk “sure-fire” bets). New financial products include a wide variety of derivatives (i.e., financial instruments whose values are tied to other financial instruments or are contingent promises to pay) and securities formed from the bundling of mortgages, creditcard accounts, or automobile and student loans. As financial instruments, players, and (especially) layers of instruments multiply, the surety provided by the stock of “permanent” money becomes increasingly stretched. For it is only this money (i.e., the money represented in the pool of fluid capital) that has permanence; the rest is subject to destruction through repayment of loans. While they cannot create money, most nonbank financial entities are nevertheless like banks in that they are subject to creditors demanding redemption on short notice. Therefore, as with a bank, prudence requires a liquid reserve, at least part of which is in the form of cash or demand deposits. In normal circumstances (i.e., when financial transactions are informed mainly by enterprise), these reserves can be augmented by the sale of short-term marketable securities or by drawing on lines of credit from banks. When confidence is not in crisis, liquidity can thus be shifted in the financial system to where it is needed simply by adjustments (usually slight) in asset prices. All that is required is for markets to be “thick” with ready buyers.20 Confidence, however, is ephemeral. While confidence is essential for economic activity to take place and an economy to prosper, it also contains the seeds of its own destruction, for as it builds it causes perceptions of risk to diminish, which is to say that it lessens both borrower and lender’s risk. More importantly, confidence tends to mistakenly transform uncertainty into risk. Hedge finance of real economic activity
20
In highly organized financial markets, this “thickness” (and thus liquidity) is provided by specialist-dealers making markets in individual securities. Even these dealers, however, are engaged in a carry trade, in that they are usually bank-financed and profit from spreads in buying and selling prices that more than cover interest costs.
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gives way to speculative and Ponzi finance, and enterprise investing gives way to speculation and wagering. Debt creation to finance asset positions increases, and financial contracts come into being (such as credit-default swaps) that are nothing more than contingent promises to pay, whose probabilities of occurring are viewed as being extremely small. All of these activities create debtor–creditor obligations that foster both bi- and multi-lateral interdependencies within the financial structure. As both the number of financial entities and the debt contracts connecting them increase, the surety provided by the stock of money deriving from the pool of fluid capital becomes ever more thinly stretched, thereby increasing the vulnerability of the financial system to collapses of confidence and liquidity demands in any one part of it. To see why this is the case, consider a financial system with N financial entities. Assuming that any two of these have the potential of creating a debt obligation each with the other, the number of potential debt/creditor connections for the structure is 2NðN 1Þ, each of which creates a potential demand for liquidity. As N increases, the number of potential financial connections accordingly increases, not as N, but as the square of N. While not all of the potential “cells” will be nonempty, enough will be to create a grid of interconnections linking every part of the system to every other part. Since the pool of “permanent” money at any point in time is fixed by past and current saving, the “inverted pyramid” of nonmoney asset values that this pool must support (in terms of liquidity) becomes ever larger. A “surprise” demand for liquidity caused by a collapse of confidence at any one of the linkages can lead to a cascading of “runs” elsewhere that is capable of bankrupting the entire system. Since the number of creditor/debtor linkages increases with the square of the number of financial entities, the probability of a such a system cascade actually occurring obviously increases with the number of linkages. In short, the greater the number of intermediaries in a financial system, the more exposed the system is to a collapse of confidence and panic. In addition, vulnerability is compounded by the layers that a financial system has, as entities in the higher layers tend to be the most levered. Hedge funds lead the pack in this regard, for in the run-up to the 2007–2008 meltdown, leverage for some reached as high as 40 to 1. While hedge funds are able to hedge normal risk reasonably well, as a group they cannot hedge uncertainty in the form of “black-swan” collapses of confidence (or what is now referred to as systemic risk).
16.4.2
Lessening of Borrower and Lender’s Risk
A second factor contributing to financial panic is the lessening of borrower and lender’s risk that accompanies the buildup of confidence. As noted in the previous chapter, fulfillment of expectations leads to prospective quasi-rents being capitalized at lowered discount rates and for lenders to tolerate more risk in the pursuit of higher returns. Success not only obscures uncertainty, but, even worse, causes it to be treated as risk. The result is that much of finance evolves from being
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enterprise-based into speculative and Ponzi and investment in financial assets from enterprise into speculation and wagering.
16.4.3
Spiking of Expectations
As has already been emphasized, a third prelude to financial panic is a concentration of expectations at the current prices of financial assets; stability in markets requires a diversity of opinion. When everyone is a bull, then mass psychology is such that a switch of even one participant to bearish sentiment can cause a massive shift of all. The result will be one-sided markets in which all are sellers and there are no buyers, with prices obviously in free-fall.
16.4.4
Asset Prices Outpacing the Increase in the Pool of Fluid Capital
A central tenet of this study is that asset prices, both in the aggregate and across broad asset categories, cannot in the long run increase faster than the increase in the underlying pool of fluid capital (or, equivalently, by the rate of growth of the economy).21 When this dictum is violated, as seems inevitable during boom times in capitalist economies, the increase in asset prices in excess of the increase in the pool of fluid capital is necessarily being fueled by the creation of new money. This is money, as has been noted, that, until it is transformed into “permanent” money through saving, coexists with loans, and thus has a tenuous existence. Two comments are relevant here. The first is that, as we have seen, the aggregate value of financial assets is bounded by the value in current prices of the goods that are implicit in the pool of fluid capital. The second comment, also as we have seen, is that the floor to asset values during times of financial panic (i.e., when liquidity preference is nearly absolute) is given by the stock of “permanent” money (that is, by the money that remains in the claims side of the pool of fluid capital). When asset prices (as a group) outpace the increase in nominal value of output, the process, as described in the last chapter, can become self-sustaining (at least for awhile) as price increases today lead to expectations on the part of speculators and wagerers of further price increases tomorrow. A bubble (or bubbles) is thereby created – enabled by IOUs of some sort or another somewhere in the financial system – which will eventually burst, whether from a spiking of expectations or a collapsing of confidence emanating from an outside source.
21
Remember, it is fluid capital that gives value to gold (or any other asset), not the reverse.
16.4 Preludes to Panic
16.4.5
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Explosion of Derivatives Trading
Hedging against unforeseen price changes and acts of nature is about as old as exchange and trading itself, historically almost all of which involved payment in connection with a specified body of goods or service. What is new is a proliferation of contracts involving promises to pay that depend upon the occurrence of some contingent event. An extreme instance is where X places a bet with Y that something bad (such as the failure to pay a debt) will happen to Z, which is nothing more than a flat-out gamble. Credit-Default Swaps (CDSs) are a more standard real-world example.22 Such swaps are seen by lenders as transferring the risk of default (i.e., lender’s risk) to a third party, and, so long as the price of the contract is reasonable (in relation to the interest rate on the loan), the lender can feel justified in making the loan no matter what its actual risk might be. In moderation, and guided by enterprise, such contracts are clearly conducive to transferring risk (obviously for a fee) to those willing to bear it, thereby making the capital market more efficient. However, things get out of hand when almost any loan, no matter what its risk (let alone any allowance for uncertainty), can find a seller of default insurance who in turn is able to pass the contract off to yet another party through securitization. By the time that the swap contract is bundled with similar other contracts and securitized, the default risk of the original loan is likely sufficiently opaque that the new (perhaps now fractional) owner of the swap, who was paid a fee to assume its contingent liability, does not really know what its true risk is. The original lender at this point would appear to have a risk-free high return on its loan, the writer of the CDS is happy with what in effect is an up-front origination fee, and the holder of the securitized CDS is undoubtedly content as well, but is probably only vaguely aware of the risk that has in fact been assumed. The problem with derivative contracts as financial instruments is that, since no payment for actual goods or services is involved (but rather promises-to-pay contingent upon the occurrence of a specified event), there is no limit to the number of such contracts that might be written. Options, for example, can be piled
22 There are many kinds of swaps besides credit-default, including interest rate, currency, and bond. For a very readable account of the varieties and their history, see Tett (2009, Chaps. 1 and 2). See also Brunnermeier (2009). Although the American International Group (an insurance company) has garnered the bulk of negative attention in connection with CDSs, the primary providers of credit and loan insurance have been banks and hedge funds. One of the first credit-default swaps put together was in connection with a large contingent credit line that J.P. Morgan had extended to Exxon in anticipation of damages stemming from the Exxon Valdez disaster. In transferring the default risk of the credit line to the European Bank for Reconstruction and Development (EBRD), Morgan was able to convince regulators that, though the credit line remained on its books, the credit line was now risk-free and therefore should not be subject to any capital encumbrance. The swap was seen as win-win all around: Exxon’s credit line was not affected, the EBRD had a profitable new stream of income at a cost of taking on little apparent risk, and Morgan had freed-up capital for the funding of new loans. [See Tett (2009, Chap. 2) for details.]
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onto options, which, in turn, can be piled on additional options, and so on and so forth.23 Moreover, for derivative contracts to be sold, the purchases must be financed, and much, if not most, of the finance involved is with newly created money borrowed from banks. In short, what we have is casinos with banks.
16.4.6
Activities of Hedge Funds
Imagine a casino that has virtually an infinity of games that can be played, with the only essential rule being that losing bets have to be paid on the spot. Apart from this, there are no house rules: computers can be used to count cards, time-series data are available from roulette tables and slot machines that can be analyzed and modeled for nonrandom behavior using the most advanced statistical and econometric techniques, etc. Players are combines with large stakes, and can not only participate directly in the games, but can also devise bets on one another’s wagers. Moreover, and most importantly, the players’ stakes consist mostly of borrowed money! Such, without too much exaggeration, is an apt description of the purpose and activities of current-day hedge funds. Again, casinos with banks!
16.4.7
Globalization of Finance
The years following the terrorist attacks of September 11, 2001, were clearly very good for world economic growth, but were even better for financial services and finance in general. Revolutionary advances in computer and communication technology, together with liberalization of money and capital markets in many countries, have essentially made for the world becoming a global electronic village, which, among other things, allows for the rapid transfer of money from virtually anywhere in the world to anywhere else. As an example, a low-income saver in Indonesia (say) can help finance the purchase by a US household of a flat-screen television set made in China or, alternatively, can contribute to the finance of a new automobile plant in Tennessee.24 The sums that move daily (or even hourly) 23
If one takes derivative in its mathematical sense, one can imagine a function that is continuously differentiable of any order and contingent promises-to-pay being written for each derivative, first, second, third, etc., Alternatively, a group of assets can be bundled into securities, which in turn can be bundled with other securities into still another level of securities, and so on and so forth. In December 2008, the total nominal value of outstanding OTC derivatives for the G20 countries plus Switzerland (as reported by the Bank of International Settlements) was about $600 trillion, which compares with a world GDP for 2007 of about $55 trillion! 24 Although the globalization of finance has critics, the point in this example is clearly one of its most striking successes. In the late 1960s, the author spent a year and a half with a group of advisors to the Colombian Government. At the time, the only “official” outlet for low-income saving in Colombia were savings accounts paying nominal 4% or so interest in the context of an inflation rate that was typically of 8–10%. Lotteries had a higher expected return, and it was no wonder that they flourished amongst the poor. Today, low-income savers have access to a variety of financial instruments in which to place their savings at competitive international rates.
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through the world’s financial channels are now huge, and greatly facilitate the flow of world savings into its most productive uses. All of this is obviously to the good. The downside is that, with world financial markets now so highly interconnected, a crisis, that in the past would have been isolated pretty much to its country of origin, can quickly become a global catastrophe.
16.5
The Uniqueness of Banks and the Lender-of-Last-Resort
Anyone, by penciling promises to pay, can create a potential means of payment. The kicker, of course, is getting such liabilities accepted by others. Banks accordingly are unique, in that they are the only private institution whose liabilities are accepted means of payment; in short, they can create money. However, since banks not only operate according to the Banking Principle in pursuing profit, they are also subject to the brutal devastation of the Banking Disease. As a consequence, during times of financial distress when liquidity preference is high and the public’s demand for money to hold as an asset is at a peak, banks’ motivation to provide such is exactly opposite to the demand. For they, too, are subject to liquidity preference, and their incentives in the circumstances are to call in or not renew existing loans and to be extremely cautious in any new lending.25 Thus, at a time when the public is most demanding of money to hold as an asset, the one private institution that has the ability to create money is, for the most part, either not in a position or else reluctant to do so. Historically, most financial crises involved banks running out of reserves; thus the need arose for a lender-of-last-resort, an institution that can provide wanted reserves and, should circumstances require, be able to create money directly. Such is now the province of most central banks. In ordinary circumstances, a central bank provides reserves to the banking system either through the purchase of government securities in the open market or by the discounting of loans made by commercial banks through the central bank’s discount window. In most situations, this is sufficient to get credit flowing again. But not always. As the events of 2008–2009 have demonstrated, flooding the banking system with reserves, as was done by the central banks of the USA and Europe, is not enough. For when the public is in fullblown financial panic, and liquidity preference is near absolute, it is not money created through a promissory note that is wanted, but rather money in exchange for
25
With the advent of deposit insurance, banks, in general, are no longer subject to the runs by depositors that were their historical bane. Now, the principal risk (besides that related to default on loans) that they face during times of financial distress is the write-downs on assets that are forced under “mark-to-market” rules. This loss of capital, in conjunction with greatly increased lender’s risk, makes for great reluctance by banks in taking on new liabilities. The much safer course for them is the purchase of risk-free government securities.
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existing financial assets. In this situation, it is the duty of the lender-of-last-resort to accommodate such demands.26
16.6
Some Observations on the Financial Meltdown of 2007–2009
We are at last in a place to comment on the events leading up to and involved in the financial crisis of 2007–2009, beginning with the following background and contributory factors:27 1. Inexpensive goods produced in Southeast Asia, especially in China, which kept a lid on inflation and allowed the Federal Reserve to maintain low interest rates in the USA. 2. Huge savings in China from trade with the USA which, in turn, financed much of the US Federal Budget Deficit and US households’ extremely low (even negative) saving rates.28 3. Deflation in Japan that led to extremely low Japanese interest rates, enabling a carry trade to flourish in which international banks and other financial entities borrowed in yen and loaned at much higher rates in dollars, pounds, euros, and other currencies. 4. Federal Reserve monetary policy, following the dot-com boom and 9/11 attacks, that kept short-term interest rates extremely low for too long in the USA. 5. Social policy during the Clinton and Bush II Administrations that pursued a goal of increasing home ownership from a historically stable figure of about 64% to upwards of 70%. 6. Securitization of mortgages (and other financial paper) in the USA that allowed funds, institutions, or individuals anywhere in the world to provide finance for the US housing and consumption booms. 7. Lax oversight by regulatory agencies that (a) allowed for an explosion of subprime mortgages to be originated, (b) allowed for bond-rating agencies to ascribe AAA ratings to securities heavily infused with such mortgages, and (c) did not react to the dangers that these created for the balance sheets 26
It would appear to be recognition of this that prompted the Federal Reserve in the fall of 2008 to begin guaranteeing money-market funds and even to the direct open-market purchase of mortgages, long-term government bonds, and private securities. The challenge for the Federal Reserve will be to unwind its position in these assets in an orderly way as liquidity preference abates. That liquidity preference became near absolute in the late summer and fall of 2008 is evidenced by the virtual seizing-up of all financial markets except for US Government securities, with zero (or even negative) rates on short-term bills and notes. Owning short-term US Government securities in these circumstances was essentially the same thing as holding money. 27 There are a number of very readable accounts and narratives of the 2007–2009 crisis, two of the best, in my view, being Gasparino (2009) and the Postscript to Chap. 7 of Akerlof and Shiller (2009). 28 The extremely low household saving rates during this period is mindful of the Cambridge (England) approach to income distribution, in which “Wage earners spend what they get, and capitalists get what they spend.” [See Minsky (2008, Chap. 7).]
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(and ultimate solvency) of the financial institutions that were purchasing and marketing them. While the financial crisis of 2007–2009 is the most severe since the Great Depression of the 1930s, it has the common characteristic of every financial crisis, namely, a collapse of confidence and rush to the security of money. What is so different about this crisis is not only its global spread, but its near complete shattering of trust and confidence, which left uncertainty bare and liquidity preference nearly absolute. If there ever has been an instance of Keynes’s liquidity trap, the fall of 2008 was it. In the popular view, the proximate cause of the financial crisis of 2007–2009 was the bursting of the housing boom in the USA in the housing market and subsequent fall in housing prices that then triggered massive defaults in the subprime mortgage market, which, in turn, spread to insurance companies that had written massive volumes of CDSs (in particular, AIG), banks (both commercial and investment and both domestic and international), commercial paper, hedge funds, etc., in short, to virtually every large (and not so large) financial entity in existence. For the author, the only quibble with this view is that the bursting of the housing market was not the single cause of the crisis, but only the place where it started (at least in the USA). So much monetary excess had been built up between 2002 and 2007 that a crisis was inevitable; housing was simply a natural and ripe place for it to begin. With this, let us now turn to a discussion of the excesses in question and why a crisis (though not necessarily of the magnitude that actually occurred) was inevitable. The place to begin is with the pool of fluid capital and its growth, the point being that, as has been argued throughout this study, the aggregate of asset values cannot, over any extended period of time, increase faster than fluid capital. As noted near the end of Chap. 14, the goods component of fluid capital in a high-income economy can pretty much be identified with the total of goods in process, which means that the pool of fluid capital will grow at essentially the same rate as GDP. In 2007, GDP (in current prices) was about 32% higher than in 2002, which implies that the aggregate of asset values (i.e., wealth) supported by fluid capital would have been larger by about the same amount. Because returns tend to equalize in the long run across markets, the same would be true for broad asset categories, such as housing. According to the Case-Shiller 20-City Housing Price Index, housing prices in the USA were 85% higher in June 2007 than they were in June 2002, which implies a rate of increase over the period of more than double the increase in fluid capital.29
29
By way of comparison, the Dow-Jones Industrial Average increased over the same period by 45%, an amount much more in line with the increase in fluid capital. As is to be expected, increased housing prices of this magnitude gave rise to a boom in new home construction, especially in warmweather venues like Florida, Las Vegas, Southern California, and Arizona. Although some of this new construction reflected “legitimate” demand arising from desires for second homes (related to increases in income), retirement homes, and a substantial increase in home ownership (how this was financed, however, is a different matter, and was/is part of the problem), much was the result of raging animal-spirit speculative over-building. Speculation/wagering was also key in driving up prices, in that many homes were acquired by “flippers” whose only motivation was to obtain a higher price tomorrow.
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Price increases in excess of the increase in fluid capital of this magnitude for an asset category as important as housing can only be financed in the following ways: 1. 2. 3. 4.
Creation of new money Increases in velocity Creation of debt Money from abroad
Of these four sources of funds, the one that leaps out when the numbers are examined is debt creation, for between 2002 and 2007 nonfarm mortgage debt in the USA increased an astounding 75% (again, keeping in mind that GDP increased just 32% during this period).30 As the M1 money supply increased only 12% (M2, 28%) during the period, it is clear that velocity in the financial circulation had to increase substantially. How this came about can be seen as follows. Assume that a home priced at $500,000 is purchased with cash of $50,000 and a $450,000 mortgage that is originated by the ABC Mortgage Company. Within a few days (or perhaps even a few hours), the mortgage is sold by ABC to a bank, perhaps even the bank that provided the finance to the escrow company involved in the transaction to begin with, who then sells the mortgage to an “aggregator” that bundles it with a large number of other mortgages or other debt instruments (such as creditcard and automobile debt) into collateralized debt obligations (CMOs, CDOs, etc.) for eventual sale to the investing public (including investors outside of the USA).31 Throughout this chain of transactions, the actual cash involved is kept to a minimum. While newly created money provides the initial funding for the mortgage, much of this will be erased when an already existing mortgage on the property is paid off. Still more money will be destructed (from repayment of all or part of the loan that originally funded the mortgage) upon sale of the mortgage to the investing public, for most (if not all) of payment to the affiliated parent bank (or the “aggregator”) will be from funds raised in the overnight-repurchase (“repo”) or commercial paper markets or from other investors. Moreover, even less money would be involved if, as was the case with many subprime mortgages, the mortgage covered the full price of the house. Thus, we see that as the proportion of sale prices that is financed with IOUs increases, a given amount of money in the system is made to support an ever larger number of transactions, thereby increasing apparent velocity. In short, while prices are increasing, and new mortgages with little or no down-payment proliferate,
30 Despite the weak dollar during the period, it does not appear that money from abroad was of much direct consequence in the housing market. Where foreign money was a factor was in the purchase of securitized mortgages in secondary markets. 31 As the “toxicity” of the subprime mortgages in the securitized debt pools started to become apparent in late 2006 and 2007, their creators (with Merrill Lynch, Citigroup, and Bear Stearns leading the way) increasingly had to keep portions of the CMOs and CDOs on their balance sheets, whether directly or in off-balance-sheet vehicles (SIVs, conduits, etc.). Their toxicity was thought to be insured against through the purchase of credit-default swaps.
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actual money movement can appear almost to stand still.32 The problem, of course, is that the underlying stock of money is being forced to support an ever larger quantity of debt. Money in these circumstances may not be needed when mortgages are being written, but obviously will be when defaults and foreclosures set in, as has indeed been the case. Finally, that a crash in the housing market was inevitable follows from the fact that, for reasons already cited in this and the preceding chapter, bubbles eventually have to burst. When the crash in the housing market occurred in 2007, and the subprime mortgage market fell into disarray, authorities in the USA thought that it could be “contained.” But this obviously turned out not to be the case. Current-day monetary economies simply have too many interconnections among credit, debt, and asset markets for a battering of confidence in a venue as large as housing not to spread. What could not be contained was the effect of falling housing prices and values of associated assets from affecting the balance sheets of lending institutions, especially those of commercial banks. Confidence ultimately collapsed everywhere, and liquidity preference ruled supreme. The authorities also could not staunch the collapse of confidence in financial markets from affecting the real economy. The bursting housing market meant a collapse in residential construction, and the drying up of credit applied a coup de main to new-car sales, which had already been battered by high gasoline prices. Finally, the collapse of confidence and glaring bareness of uncertainty (in conjunction with real and prospective increases in unemployment) caused households to increase sharply their saving rate. When housing, automobiles, and consumer spending are jointly in the tank, the real economy is obviously in deep trouble. Money is a marvelous social invention, but it brings with it an inherent instability. Financial crises always involve a confrontation between confidence, uncertainty, and money. If uncertainty did not exist, there would be no need (as emphasized by Keynes in his 1937 defense of the General Theory in the Quarterly Journal of Economics) to hold money as a store of value. However, because uncertainty does in fact exist, money is the only asset that can fully hedge against it. In these circumstances, money is connected to uncertainty through confidence and liquidity preference. Confidence, which is subject to unpredictable and at times violent change (almost like “a leaf blown in the wind”), obscures uncertainty. When confidence disappears, liquidity preference surges. While the bursting of the housing boom may have been the initial spark, the ultimate cause of the meltdown of 2007–2009 was an intertwining of confidence, uncertainty, and liquidity preference. The only thing that is really different about this crisis from those in the past is its worldwide breadth and degree.
32 The tapping of home equity through increased primary mortgages and home equity lines of credit does have a direct effect on the stock of money, for such “ATM” transactions lead to increased deposits, which ultimately are created through loans from commercial banks.
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16.7
16 Booms, Busts, and Financial Panics: The Financial Meltdown of 2007–2009
Lessons for Reform
At the time of writing (January 2010), thoughts of reforming financial regulation in order to prevent a 2007–2008 meltdown from ever happening again are much in the air. While reform is obviously needed, the author’s opinion is that any thought of ever being able to forestall financial crises is an ignis fatuus (i.e., a will-o-the-wisp). For to be able to do so would require (among other things) a fine-tuning (with foresight) of mass confidence, which is simply not possible. With this in mind, the following observations and suggestions are offered as inputs into a meaningful and useful reform. To begin with, it needs to be both recognized – and understood! – that monetary economies consist of not one, but two, aggregate markets, the first a market for goods and services and the second a market for assets. Included in asset markets will be both financial and real assets, including houses and stocks of commodities to be held over from one period to another. Markets for goods and services are driven primarily by income and the desire to invest in new capacity to produce. Demand functions in these markets are generally stable and downward sloping. The markets for assets, on the other hand, are driven by savings (i.e., by the claims side of the pool of fluid capital). Their demand functions are frequently highly unstable, and because of this instability often appear to slope upward.33 All too often, the returns that are chased in asset markets are capital gains, rather than interest and dividends, with the result that price increases in asset markets attract attention, and are ever vulnerable to the whims of speculation and wagering. Historically, central banks (when not functioning as a lender-of-last-resort) have focused monetary policy on goods prices, rather than on asset prices, the rationale being that goods prices are the most important prices in an economy and that asset markets are rational and ultimately self-correcting. This is a seriously mistaken policy focus in my opinion for two reasons. In the first place, it overlooks the fact that financial crises always have their genesis in the asset market, not the goods market, and, secondly, it assumes (against massive contrary historical evidence) that asset markets are inherently stable. If the only activity in financial markets entailed the transfer of funds from savers to those investing in new capacity to produce, then a good case could be made for stability. However, this most certainly is not the case, as, inevitably, much of the activity in financial markets is driven by movements in asset prices themselves (rather than by expected future interest and dividends), all of which is dependent upon the interactions of confidence, uncertainty, and liquidity preference, and therefore highly unstable. We are accordingly brought to the question: Can a central bank, and specifically the Federal Reserve, focus policy on both goods and asset prices with the goal of
33
Perhaps the most important distinction between goods and asset markets is that, in terms of behavior, an increase in price in a goods markets elicits an increased supply from an upward (but not vertical) supply curve. In asset markets, in contrast, stocks are fixed (at least in the short run), which is to say that supply curves are vertical spikes.
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being able to control both? In my opinion, the answer is yes, but only with the proviso that policymakers monitor the proper quantities. Since financial crises involve money, the key is obviously to focus on the danger points of money creation. In doing this, the following principles should apply: (a) In the goods market, the concern should always be with whether the banking system is providing the appropriate amount of finance for current production. (b) In the asset market, the focus should be on making sure that money is not being created simply for purchasing existing financial assets or that assets are not being mortgaged simply for acquiring other assets. Based on these two principles, an imagined ideal financial structure would consist of the following elements: 1. A commercial banking system that would be able to create deposits for two purposes, and two purposes only: (1) for finance of current production and (2) for “bridge” finance of investment in new produced means of production. 2. Investment banking houses whose functions would be restricted to the raising of financial capital for investment in new produced means of production, underwriting and placing of equity and bond new-issues, and the provision of brokerage services. 3. Insurance companies that underwrite policies essentially as today, but with limited ability to insure against loan and bond default. 4. A bevy of nonbank financial intermediaries, mutual funds, money-market funds, pension funds, mortgage houses, hedge funds, brokerages, etc., that can manage wealth, trade, and originate loans and provide limited deposit transfer and payment services, but would not be able to borrow from banks or other financial intermediaries to lever assets. The motivation for the foregoing is very simple, namely, a desire for business borrowing to stay within the bounds set by hedge finance and for speculative/wagering activities in asset markets not be financed through money creation. In substantial part, the system envisioned would be a return to the one that prevailed in the USA from the mid-1930s until the wave of financial deregulation that began in the 1980s. Items (1) and (2) would essentially resurrect the Glass–Steagall Act by once again providing for a firewall separating commercial and investment banking. Item (3) would regulate insurance companies in terms of the risk that could be taken on vis-a`-vis financial instruments. The key provision of Item (4) would be the prohibition of borrowing from banks by hedge funds and other institutions (including investment banks) for the finance of trading and taking of positions in derivatives and the purchase of equities and synthetic securities on margin. In short, no longer any “casinos with banks”! Prohibited as well should be extension of credit lines by banks to off-balance-sheet structured-investment-vehicles, indeed, even prohibition of such entities altogether. For nonfinancial corporations, lending arms should be permitted, but not “trading desks.” As a further means for constraining systemic risk, practical leverage ratios should be imposed on all participants in loan transactions, and then enforcing these
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ratios by penalizing lenders as well as borrowers when they are exceeded (i.e., requiring lenders to know their borrowers’ leverage). The essential points in all this is (1) for the banking system to provide the financing and new money needed for the economy to grow in an orderly noninflationary way and (2) to prevent speculation/wagering from gaining footholds in asset markets. Confidence and animal spirits need to be nurtured in both goods and asset markets, but speculative and Ponzi finance of investment and speculation and wagering in asset markets have to be kept at bay.34 What obviously has to be guarded against is a sequence of events that leads to a crash of confidence and subsequent rush to the security of money. Prohibiting the borrowing of money in order to purchase financial assets and, for real assets, prohibiting the mortgaging of one asset to buy another, will be important steps to this end. Where does the monetary authority fit into all of this? In its two traditional roles, that is, as a provider of reserves to the banking system and as the lender-of-lastresort. With respect to the former, what needs to be done is for central banks to better monitor – and, indeed, scrutinize – the type and quality of credit that banks are extending, and also make more use of the discount window as a source of credit to banks, rather than relying, as has been the case for several decades, on openmarket operations for adjusting banks’ reserves.35 However, if history is any guide, then, despite regulator efforts along the lines suggested, financial crises (though hopefully not with the severity of the one of 2007–2009) would in all likelihood still be a danger. Should a crisis occur, the central bank, as the lender-of-last-resort, must stand ready to provide as much money for the public to hold (as an asset) as is demanded. The vehicle, and portal, for this should be (as was the case in the 2007–2008 meltdown) the discount window. All financial intermediaries experiencing liquidity runs (mutual funds, money-market and bond funds, hedge funds, etc.) should have access.36 The challenge, obviously, is that the central bank take back the liquidity in an orderly way once liquidity preference begins to abate.37
16.8
Summary and Wrap-Up
While the preceding suggestions for improving financial vigilance and regulation might seem simple and straight-forward, they would in fact involve a virtual sea34 This stricture is not intended to foreclose nonbank financial intermediaries from borrowing from banks, only the levering of assets to purchase other assets. Lines of credit and borrowing for liquidity needs would be permitted. 35 The traditional route that credit was effected in the USA was by getting the banking system in debt to the Federal Reserve through open-market operations in order to force banks to the discount window, for it is (or was) there that banks could really feel the force of scrutiny and credit “counseling.” This tradition needs reinstatement. 36 The only eligibility requirement should be that the assets discounted be of investment grade. 37 At time of writing (Winter of 2009–2010), prospects of this challenge being met by the FED and other central banks are not encouraging.
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change in the public and regulators’ view as to how asset markets operate. In the first place, it requires that monetary authorities recognize that asset prices as well as goods prices require careful monitoring and that in the long run asset prices (both collectively and for broad asset classes) cannot meaningfully increase faster than the rate of growth (in current prices) of the underlying economy. This rate of increase keeps asset values in line with additions of saving to the pool of fluid capital. Any increases in “wealth” that are in excess of these additions are illusionary, and are fueled either by the creation of money not related to real production or by a layering of IOUs. By not allowing the banking system to finance the trading activities of nonbank intermediaries, such as mutual, money-market, and hedge funds, a major step would be taken to forestall such excesses. In the second place, it must be recognized that uncertainty is separate from risk and that any reduction of uncertainty, at least in the short run, is also an illusion, an illusion caused by it being masked by mass confidence. Confidence is a marvelous phenomenon, for it is what makes a capitalist economy tick, but it is always subject to collapse, leaving money as the only refuge against the tsunami of uncertainty. As pointed by Keynes in the General Theory,38 this intertwining of confidence, uncertainty, and liquidity preference is an inescapable feature of a monetary economy, and, in the author’s opinion can only be contained by vigilance by the monetary authority that uncertainty is not being transformed into illusionary risk through speculation/wagering. Also, it should be clear at this point that, at least in the author’s opinion, the instincts of the Glass–Steagall Act in separating commercial banking from investment banking were sound and that this separation should be resurrected. The financial system in a free-market capitalist economy has basically two functions, both of which involve the movement of purchasing power from savers to investors, namely, the finance of current production and the finance of investment in new produced means of production. History, I think, is pretty clear in showing that the former is best performed by commercial banks (operating on the Banking Principle) transforming short-term deposits into short-term self-liquidating loans. By adhering to this precept (which, in effect, is simply the venerable Real-Bills Doctrine), new money that is created is always tied to real activity. The function of transforming savings from the pool of fluid capital into investment in produced means of production is then the province of investment banking. Unlike in the finance of current production (including construction loans), no new money is created in the process of doing this. Existing money in the pool of fluid capital is removed from the pool to redeem construction loans, and thus providing for the permanent finance of newly produced means of production. These (the finance of current production and construction and the permanent finance of investment) are clearly two separate, but equally important, functions of capitalist finance that are best not executed under the same roof. Finally, something that has not been mentioned, but which is clearly a lesson implicit in the 2007–2008 financial meltdown is a need to somehow lessen the disconnect between the risks facing an employee of a financial organization and those facing the
38
And even more lucidly in Keynes’s 1937 article in the Quarterly Journal of Economics.
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organization itself. Consider, for example, a high-powered trader on the trading desk of a large multinational bank. Assume that the trader has had an extremely successful string of quarters (or years), for which he/she has been amply rewarded with bonuses accumulating in the hundreds of millions of dollars. The risks facing the bank in this situation are the usual ones of trades not turning out as expected. For the trader, however, short of doing anything criminal, the worst that can happen should his/her luck turn sour would be to be fired. Assuming that most of the earlier bonuses are parked in Treasury securities, the trader could then either retire at an early age or else (which is more likely) move on to the trading desk of another institution. On the other hand, the costs to the bank of unfortunate trading activity could be severe, especially if the amounts wagered were significant in the bank’s trading stake. The worst-case risks involved are clearly asymmetrical: firing for the employee (but nevertheless perhaps laughing on the way to another bank), possible bankruptcy for the firm. As another example, let us move up a notch or two in the bank’s hierarchy and consider the decisions made by those in charge of managing risk. Assume that a strategy is aggressively pushed that encourages the assuming of what would ordinarily be seen as a large amount of risk (such as the accumulation of large positions in BBB-rated mortgage-backed securities), but with the risk of default “hedged away” through the purchase of like amounts of credit default insurance, all of which is done on the assumption that default correlations amongst the securitized mortgages are zero. When the latter turns out not to be the case, and, even worse, that the counter-parties providing the insurance also default, the bank is faced with an even worse disaster. Again, there is a severe asymmetry between the risks faced by the decision-makers and the risks that their decisions load onto the firm: firing (with likely generous golden parachutes on top of what were probably already healthy salaries) vs. likely bankruptcy (or a taxpayer bailout) of the firm. Although agency problems of these types are a hallmark of limited liability corporate structures, the mismatch between the risks faced by a firm’s employees and those of the firm for whom they work is especially pronounced in current-day financial entities, and is undoubtedly a factor in magnifying systemic risk. There once was a time, not all that long ago, when investment banks were all partnerships, in which case those responsible for ill-advised decisions had to bear their effects. However, while partnership structures for investment banks and brokerages were clearly useful in constraining reckless behavior in the past, the problem is that partnerships, in the absence of borrowing from banks, would be unlikely today to command the capital needed to serve international financial markets competitively.39 Curtailing recklessness in present circumstances, accordingly, is almost certainly going to have to rely on indirect individual behavior management 39
At the end of 2008, Brown Brothers Harriman (BBH) was the only old-line US investment bank still operating as a partnership. Its capital consisted of $6 billion in assets and about $500 million in capital provided by 39 partners. JP Morgan, by contrast, had $2,052 billion of assets and $139 billion of common equity (of which, $134 billion was due to “other assets”). I am grateful to John Britton for bringing BBH and these disparate figures to my attention, as well as his enlightened insights concerning the points in these paragraphs.
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(monitoring of borrower and lender’s risks, limiting of leverage ratios, etc.) as described in the preceding section. Much has been made in these postscript chapters of the consequences of capitalist finance devolving into “casinos with banks.” In closing, a few words about real casinos are in order. As a consequence of litigation over a tax lien received in the early 1970s by a Native-American Chippewa couple living on Indian lands in northern Minnesota that eventually reached the US Supreme Court, a door was opened to Indian Nations being able to operate gambling establishments on their lands without regard to state law.40 Prior to this decision, the only states in which casino gambling was legal were Nevada and (in 1976) New Jersey. With casinos on Indian lands starting to boom, other states, not to be outdone in a quest for revenues, joined the fray, first allowing casinos on river boats on the Mississippi and Missouri, and then on terra firma near areas of large population density. As of 2008, there were more than 1,700 legal gaming establishments in the 50 American states, of which more than 1,500 were legally licensed casinos. The point to be made is that gambling, whether in real or financial casinos, appears unfortunately to be increasingly ingrained in American life.41
40
See http://www.wikipedia.org/wiki/native_american_gambling_enterprises. Indeed, wagering in legal gaming establishments is one of the fastest growing components of National Expenditure. Between 1999 and 2007, the total of all gaming receipts (pari-mutuel wagering, lotteries, casinos, legal bookmaking, charitable gaming and bingo, Indian reservations, and card rooms), defined as total wagers less amounts returned to players, increased nearly 60% (to $92.3 billion), compared with growth in GDP over the same period of about 50%. (See http:// www.americangaming.org.) Although not really documented, a likely factor making for an increased propensity to gamble amongst the American public has been a significant disconnect between personal discount rates and the rates at which consumption can be financed through borrowing. Events such the dot-com collapse in 2000 and the terrorist attacks of September, 2001 clearly lead to increased personal discount rates, while the extremely low interest rates following these events (together with the flood of savings from abroad) served to favor consumption today (including gambling) as opposed to consumption tomorrow. 41
Appendix A On the Role of Theory in Economic Analysis
Introduction The purpose of this appendix is to offer an assessment of the role of theory in the practical applications of economic analysis. More than any other social science, economics has a well-developed body of theory that is de rigueur for aspiring young economists to learn, and which informs and guides both empirical research in economics and practical advice on economic policy questions of the day. For more than a generation, economic theorists have stood at the pinnacle of the discipline, and for years economics departments have practiced peer review in terms of the stature of their resident theorists. And in keeping with this, the vast majority of Nobel prizes in economics have been awarded for contributions to economic theory. Yet, in no discipline is the role of theory a completely settled matter, including physics, the science that economics most aspires to emulate. Despite the fact that modern physical theory is for all intents and purposes formal mathematics, there is amongst physicists whether mathematics is “nature’s language” or is simply a tool for discovering her laws. Modern economic theory is almost as mathematized as modern physical theory, though at a lower level of mathematics, as graduate students in economics do not yet have to learn non-Euclidian geometry, complex variables, and non-Abelian group theory. And there is wide support within economics for the view that mathematics is also the language of economic behavior. It is not my intent in this appendix to provide yet another polemic against neoclassical economic theory, but rather to assess what neoclassical theory is (and is not) capable of accomplishing in the pursuit of practical economic analysis. To give some flavor of the discussion to follow, it is my view that neoclassical theory is most appropriate when the questions being asked are of the “what if ” type, or, equivalently, when choices between different courses of action are involved. It is in these situations that the strong conservation assumptions underlying neoclassical theory can reasonably be expected to be fulfilled. Neoclassical theory is inappropriate, again in my opinion, in situations that call for assessment of real-time events.
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Comparative statics/comparative dynamics are appropriate for assessing conceptual contingencies, but are almost never appropriate for modeling the unfolding of realtime dynamics. The questions addressed in this appendix are ones that have troubled or puzzled me for years, but it was not until I read a book by Mirowski (1989) on the relationship of neoclassical economic theory to nineteenth-century mechanics that I have been able to identify the root causes of some of my problems. Especially illuminating for me in this regard is Mirowski’s discussion of what the conventional neoclassical assumptions of given endowments, tastes, and technology mean in terms of conservative systems, and why conservative systems of the nineteenth-century variety are ill-equipped to analyze real-time economic phenomena. The points I am interested in discussing can all be conveniently illustrated in the context conventional theory of consumer choice. The questions of interest will be identified in the next section.
Economic Theory in Action: The Theory of Consumer Choice The theory of consumer choice is widely viewed as one of the real triumphs of economic theory, for it yields a conclusion that is not only elegantly derived, but also intuitively satisfying, and felt to be in accordance with real-world behavior. The conventional theory of consumer choice is, in form, a conservative nineteenthcentury physics energy system. The utility function is the counterpart to the potential energy function, while the income (or budget) constraint is the counterpart to kinetic energy. Marginal utilities form an invariant vector field of “forces,” and the “work” function has its counterpart in an expenditure line-integral. The invariants in the choice problem are that marginal utilities are independent of the “path of motion,” while the conservative principle that is counterpart to the conservation of potential and kinetic energy is that the sum of utility and income is conserved. The structure that the vector field of marginal utilities has to satisfy (in vector field terminology) is that the curl of the vector field must be equal to zero, which is to say that the vector field must be “irrotational.” In economics terminology, these restrictions represent the well-known integrability conditions.1 A number of standard and widely known results have been derived from the neoclassical theory of choice, including a “law of demand,” which states that (income-compensated) demand functions slope downward. The neoclassical 1
Economists are well-versed in linear algebra, this is generally not the case with respect to the concepts of vector fields. Mirowski (1989) provides some discussion of the concepts in question, but not in sufficient detail for a full understanding of the relationship between neoclassical theory and nineteenth-century conservative physical systems. The needed concepts, which include gradient, vector cross (or outer) product, curl and divergence, can be found in any standard advanced calculus textbook, such as Apostal (1957).
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framework, in some form or another, lies behind virtually all practical economic analyses of consumer choice and demand, whether qualitative or quantitative, with the apogee almost certainly being the econometric estimation of systems of demand functions that satisfy all of the analytical requirements of a conservative system. Such exercises are usually referred to as the estimation of “theoretically plausible” demand systems.2 What I wish to do now is to discuss several possible applications of the neoclassical theory of consumer behavior as illustrations of both appropriate and inappropriate uses of the theory. As mentioned earlier, neoclassical theory is most appropriately used, in my view, when the questions involved are of the “what if” variety. Such would the case, for example, if the questions being asked (with reference to a given-choice set of market baskets of goods and services) were of the form: 1. Assuming the vector of prices to be held constant, which market basket would be chosen given income A as opposed to the market basket chosen if income were B? 2. Assuming income to be held constant, which market basket would be chosen if the price vector were x as opposed to the market basket chosen if the price vector were y? The first question relates to the derivation of what are ordinarily referred to as Engel schedules, while the second question relates to the derivation of demand schedules. In neither case is there any assumption that the behavior at issue is actually to be observed. Indeed, the presumption (although usually tacit) is that it is not. Contrast these questions with the following two questions: (a) If an individual (with a given level of income A) were repeatedly (i.e., during a sequence of consumption periods) to be faced with the same price vector x, what would be the market basket of goods consumed? (b) If in a subsequent sequence of periods, the individual continued to face price vector x, but with income B rather than A, what would be the market basket consumed? In these two questions, the assumption is that consumption actually occurs within each of the consumption periods. Nevertheless, for neoclassical theory, this should not matter. The market baskets consumed in the sequence of consumption periods in (a) should be the same market basket as would have been chosen in (1), while the market baskets consumed in the sequence of consumption periods in (b) should be the same as would have been chosen in (2). Almost certainly, however, this is not what would be observed. With consumption actually taking place in (a) and (b), there would in all likelihood be an interaction between the consumption in one period and the marginal utilities operative during 2
The literature on the estimation of theoretically plausible demand systems is huge, with many monographs devoted to the subject as well as a large number of papers. See, for instance, Deaton (1975); Deaton and Muellbauer (1980); Houthakker and Taylor (1970, Chap. 5); Phlips (1983); Pollak and Wales (1992).
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the next period. Because of the intrusion of real-time dynamics, the assumptions for a conservative vector field would accordingly be violated. For the questions in (1) and (2), in contrast, this would not be a problem, for one could reasonably expect that marginal utilities would remain invariant in the face of “what if” questions, since no consumption actually takes place. I wish to emphasize that the issue involved here is not, as a practical matter, the ignoring of some factors that impinge upon consumption and that behave randomly from one consumption period to the next. The issue, rather, is one involving realtime irreversible alterations of marginal utilities in a systematic, yet not necessarily predictable, manner. The question of whether the standard paradigm can be modified in a way to accommodate such “endogenous taste changes” will be addressed below. Let me now turn to another example that illustrates the problems at issue. Suppose, as frequently happens, there is a question before a regulatory commission regarding the amount of “repression” on telephone usage that might be expected to occur as a result of a proposed increase in tariffs. In assessing this question, the usual procedure is to use a price elasticity that has been estimated from an econometric model to calculate the expected amount of repression. The expected repression can be calculated either by using the price elasticity directly or (what, in fact, is usually done) by simulating the model first under the status quo, then with the new tariff, and then attributing repression to the difference. The models in question are usually theoretically based, often with considerable dotting of i’s and crossing of t’s. Question: Is this procedure an appropriate application of the underlying theory?3 The answer is clearly yes, in my opinion, provided the question is framed in terms of comparative statics (i.e., of the “what if” variety) as opposed to real-time dynamics. However, if the question is framed in terms of estimating what the actual impact of the tariff change would be on telephone usage, then the question would involve real-time dynamics and the answer would in general be no, for the invariances required of a conservative system would once again be unlikely to be fulfilled. The upshot would seem to be that the conventional theory of consumer choice can be used in assessing alternative courses of action at a planning stage, but cannot be used in predicting the result that will materialize from a course of action actually selected. As a general conclusion, this is a correct statement, for conventional theory imposes invariance assumptions that real-time consumption behavior almost certainly invalidates. Yet, this is not to say that conventional theory cannot be modified to accommodate the invalidations that arise. This can be done, but the modifications required have to be embedded in a theoretical structure that allows for an “arrow of time.” It is to this that I now turn.
3
I leave until later the question of whether the parameters estimated in the econometric model can be identified with the parameters of the theoretical model.
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Modeling Real-Time Dynamics The central point of the preceding section is that real-time consumption behavior invalidates the invariance assumptions which underlie the neoclassical theory of consumer choice. Specifically, the theory requires that the vector field of marginal utilities be invariant to any market basket that is actually consumed. However, this is almost certainly not the case, for acts of consumption give rise to internal dynamic processes that alter tastes and preferences, and hence alter the marginal utilities defining the components of the vector field. The vector field is therefore not conservative with respect to real-time consumption (as opposed to notional consumption). Among other things, the absence of a conservative vector field of preferences means that the dynamics of real-time consumption cannot be analyzed as an exercise in nineteenth-century mechanics, which is to say that real-time consumption equations of motion cannot be interpreted in terms of a particle wending its way through a field of forces. That consumption behavior needs to be analyzed taking dynamics explicitly into account has been recognized for years, and has been the subject of much empirical research, including a number of my own efforts. For the most part, however, the dynamics that have been postulated are of a classical form. The notion of “earlier and later” is center stage, but the laws of motion ply in mechanical time, motion is reversible, and real time is important only for purposes of measurement and empirical application. Heraclitus’s dictum that “one cannot step into the same river twice” is not observed by most existing dynamical models. However, as I shall now discuss, it might seem that applied econometricians go to great lengths in attempts to assure that this is the case. Something generally not recognized, at least in the terms being discussed in this appendix, is that the conditions that must be satisfied for the validity of statistical inference in applied econometrics are in a sense isomorphic to the invariance conditions for a conservative vector field.4 For illustration, consider the estimation of a system of theoretically plausible demand functions that have been derived (say) from the Stone–Geary–Samuelson utility function. Suppose the demand functions are estimated, subject to all of the integrability conditions, from an appropriate body of data. In this situation, since the demand functions are estimated subject to the integrability conditions, a conservative vector field of preferences is not only assumed, but is, in fact, imposed as part of estimation. Assuming the econometrician is wellschooled in the Haavelmo paradigm, however, this imposition is not as mechanical as it might appear. For a number of problems have to be dealt with before estimation actually occurs, most of them related to the fact that the data set being analyzed
4
That this is indeed the case was already implicit in the classic monograph on the probability approach in econometrics of Haavelmo (1944). It is also just below the surface in the reinterpretation and extension of the Haavelmo paradigm by Spanos (1989). My own reinterpretation of the Haavelmo paradigm is given in Chap. 10 of Taylor (1994).
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arises not out of controlled laboratory conditions, but from a natural experiment generated by history. Be that as it may, the sine qua non of the Haavelmo paradigm nevertheless is a presumption that the observations in the data set being analyzed can be viewed as a sample drawn at random from a common underlying population. For this presumption to be justified, it becomes a major task of the analysis to model not only the phenomenon of interest (namely, the relationship between consumption, prices, and income), but also the structure of the natural experiment that generated the data to begin with. “Structural changes” during the period of the sample have to be taken into account, as well as the fact that most of the behavior represented in the data set will reflect disequilibria. I put structural changes in quotation marks because, in the natural experiment that generated the data, there are two different forms of structural change to contend with. The first refers to an autonomous structural change arising from the “outside” that affects preferences (and therefore consumption), but which is not, itself, consumption caused. The other form of structural change is the endogenous change in the field of marginal utilities caused by real-time consumption. Of the two types of structural change, the second type is clearly the most problematic to take into account, for it requires an explicit representation of the feedback on preferences of consumption as it occurs. The usual way of accomplishing this empirically is to specify a model in which current consumption depends not only upon current income and prices, but upon past consumption as well.5 Endogenous preference changes are assumed to be reflected in the coefficient on past consumption.6 An alternative procedure is to postulate a state-dependent vector field of marginal utilities in which the composition of the field at any point in time depends upon a set of state variables, which themselves evolve in response to realtime consumption together with the passage of mechanical time.7 If the econometrician is successful in specifying a model that appropriately takes into account the two types of structural change (and also appropriately reflects the probability structure of the random component of the implicit natural experiment), then the requirements of the Haavelmo paradigm will be satisfied. Moreover, it can also be argued that the invariance conditions for a conservative vector field will be satisfied as well. Estimation of the model can then proceed under the presumption that the parameters estimated in the econometric model are to be identified with the parameters of the underlying theory. The argument that the invariance conditions for a conservative vector field are satisfied when the Haavelmo assumptions are met can be stated as follows: If the real-time feedback of consumption on preferences is appropriately modeled, then the sample can be viewed as a sequence of state-dependent conservative vector 5
Care must be taken at this point to distinguish between mechanical dynamics that occur in mechanical time (and reflect disequilibrium behavior), and real-time dynamics that reflect the feedback of consumption on preferences. With the way that many models are specified, it is unlikely that these two forms of dynamics can be separately identified. 6 See, among others, Pollak (1978) and Von Weizsacker (1971). 7 See Houthakker and Taylor (1970) and Taylor and Houthakker (2010).
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fields in which the states are determined exogenously.8 Historical time is no longer reflected in the data, because its effects are held constant through the explicit modeling of how the states, themselves, evolve. Dynamics may still be present, but these would be of the mechanical variety and, therefore, invariant to historical time. Thus, each observation in the data set can be viewed as having arisen in answer to a “what if” type of question, namely: What quantities would be demanded if income were this and prices were thus and so? Though the conditions for a conservative vector field may be satisfied for purposes of estimation, it does not follow (as already discussed) that they would be satisfied for purposes of using the estimated model to predict the evolution of real-time consumption in response (say) to a change in prices. As was noted, one could use the model to analyze “what if” types of questions in which there is no presumption of actual consumption ever occurring. But to predict real-time consumption would require one also being able to predict the real-time evolution of the state-dependent vector fields of preferences.9 The problem, clearly, is that predicting human consumption behavior is very different than predicting the motion of an inanimate particle, for the motion of an inanimate particle does not interact with the forces defined in the field. With human behavior, on the other hand, motion does interact with these forces, for what one consumes today alters the marginal utilities that determine what one will consume tomorrow – perhaps in unpredictable ways.
Conclusions The main points of this appendix concerning the role of the neoclassical economic theory in practical economic analysis can be summarized as follows: 1. Models based upon neoclassical principles can be used in assessing the relative merits of alternative courses of action at a planning stage, but in general should not be used in predicting the outcome of the course of action that is actually selected. 2. The reason for this conclusion is that neoclassical theory postulates a conservative vector field whose components are independent of actual behavior. In the case of the theory of consumer choice, the marginal utilities defining the vector field must accordingly be independent of any market basket the consumer might consume. Invariance of the preference field is a reasonable assumption for questions of the “what if” type in which consumption is purely 8
Accomplishing this requires, in my opinion, the formulation of consumption models which have a basis in the functional organization and operation of the brain. My own first effort in this direction is given in Taylor (1992). See, also, Taylor and Houthakker (2010). 9 This is obviously a very tall order, but I am optimistic that, as we come to better understand how the brain is organized and how it functions, appropriate evolutionary laws (perhaps even of the mechanical variety) can be formulated.
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notional, but not in situations in which consumption is presumed to actually occur. Actual consumption almost certainly alters marginal utilities, in which case the preference field is not conservative but becomes real-time dependent. 3. With regard to the estimation of econometric models derived from neoclassical theory, it is argued that the conditions that must be satisfied for the validity of statistical inference (a la Haavelmo) in an econometric model are isomorphic to the invariance conditions for a conservative vector field, in which case the parameters of the econometric model can be identified with the parameters of the theory. Accomplishing this, however, requires that the realtime dependence of the field of marginal utilities be explicitly accounted for in the econometric model. 4. Although removing the real-time effects of history is, in principle, possible in estimating an econometric model derived from neoclassical theory, it is much more problematic whether real-time effects can be removed in using the model to make a prediction of actual behavior. This is the basis for the negative conclusion concerning prediction in (1). In my view, conventional economic theory is often called upon to perform tasks in practical economic analysis which is beyond its scope to execute. I have in mind particularly its use in predicting the actual outcome of an action, as opposed to assessing the relative merits of alternative actions. Comparative static or comparative dynamic analyzes based upon conservative vector fields are appropriate to the latter, but not to the former. Progress is not going to be made in rectifying the problems involved, in my opinion, until (for the study of consumer behavior) models are formulated that are embedded in the organization and functioning of the brain. Such an approach offers hope that the real-time consumption dynamics that make preference fields real-time dependent can be explicitly modeled, in which case the underlying vector fields can, indeed, be treated as conservative.
Appendix B Investment Functions Don’t Necessarily Slope Downward
Introduction One of the longtime centerpieces of economics and economic theory is that investment depends negatively upon the rate of interest. The classical economists embraced it, as did the nineteenth-century neoclassical economists and their twentieth-century descendants. The Austrians accepted it, and so did Keynes in his schedule of the marginal efficiency of capital. The only economists not to accept a negative relationship between investment and the rate of interest appear to be the Cambridge-on-the-Cam (as opposed to Cambridge-on-the-Charles) participants in the Capital Controversy of the 1960s and the 1970s. Their argument would appear to be based upon the possibility of “reswitching,” i.e., the same capital–labor ratio can be associated with two different rates of interest. The purpose of this appendix is to discuss a circumstance in which an increase in the rate of interest may well lead to an increase in investment, even though reswitching (as ordinarily understood) is not at issue. The critical factor that appears to have been ignored in previous discussions of the determinants of investment is that capital funds not only investment, but current production as well. The wellknown tradeoff between labor and capital in the method of production, therefore, means that there will also be a tradeoff between the physical capital-intensity of production and the amount of interest that must be paid in order to finance current production. In short, there is also a tradeoff between the amount of capital that is used in constructing the physical plant used in production, and the amount that is required to finance the operation of that plant. A higher rate of interest can, accordingly, lead to an increase in the capital-intensity of the method of production, in order to reduce the interest costs of production. The result may be an investment function that slopes upward with the rate of interest rather than downward. Although the words that describe the reasoning underlying the conclusion of this paper are familiar ones, the analysis is dependent upon the root concept of capital – fluid capital – that has been the focus of analysis throughout this book.
241
242
Appendix B
The Relationship Between Investment and the Rate of Interest The vantage point in the discussion to follow will be that of an individual firm considering whether to invest in additional produced means of production. Let the investment in question be represented by the present value of a stream of prospective quasi-rents: V¼
n X Ri Ci ðt; r Þ i¼1
½1 þ rðrÞi
;
(B.1)
where V is present value of quasi-rents, Ri is revenues expected in period i, Ci is avoidable cost of generating Ri, t is capital-intensity of the method of production, r is interest rate, r is discount rate, n is investment horizon. Per usual, a necessary condition for the investment to be undertaken is for the present value of the quasi-rents V to be at least as great as the cost of the investment, which will be denoted by C. The net present value of the investment as a function of t and r can accordingly be written as N ðt; r Þ ¼ V ðt; r Þ Cðt; r Þ:
(B.2)
The key to the analysis is the dependence of both the avoidable costs of production and the cost of the investment on the capital-intensity of the method of production and the interest rate. This dependence allows for the establishment of a tradeoff between the rate of interest and the capital-intensity of the method of production, and it is this tradeoff that, in turn, allows for the possibility of a positive relationship between investment and the rate of interest. Before going into detail, I should clarify what is intended to be conveyed in the capital-intensity parameter t. The usual interpretation of this parameter would be that it represents the capital–output ratio. While, strictly speaking, this is not incorrect, it is better in my view to interpret t as representing the output–labor ratio, where labor is assumed to be measured in efficiency units. Among other things, this captures the tradeoff between labor (measured in efficiency units) and the amount of capital embodied in a production process, and at the same time avoids having to treat capital as a substance once it is embodied in produced means of production. Also, as will be seen below, interpreting t as the output–labor ratio focuses attention on the interest costs of financing current production, which can be avoided through the use of more capital-intensive methods of production. Expression (B.2) is the relationship of interest because it represents the relationship between the willingness-to-pay for investment in produced means of production and the cost of that investment as a function of the output–labor ratio and the rate of interest. As noted earlier, the key to the result about to be obtained is that the pool of fluid capital funds current production as well as investment. As a consequence, the interest costs associated with the avoidable costs of current
Appendix B
243
production have to be taken into account in determining the amount of investment, as well as the interest costs of the capital associated with the investment. We can make this dependence of avoidable costs of production on the rate of interest explicit by writing Ci ðt; rÞ as r (B.3) Ci ðt; r Þ ¼ 1 þ C^i ðtÞ; 2 where C^ denotes the non-interest component of avoidable cost, and where it is assumed that avoidable costs are incurred evenly throughout the period of production. Expression (B.2) written out in full accordingly becomes N ðt; r Þ ¼
n X Ri ð1 þ ðr=2ÞÞC^i ðtÞ i¼1
½1 þ rðrÞi
Cðt; r Þ:
(B.4)
The relationship of interest is the slope of this expression with respect to r, which will be given by the partial derivative of Nðt; rÞ with respect to r, viz. h i i i1 r @ C^i dt 1 ^ r ^ n ð1 þ rÞ 1 þ þ C X 2 @t dr 2 i þ i Ri 1 þ 2 Ci ð1 þ rÞ @N ¼ @r ð1 þ rÞ2i (B.5) i¼1
@C dt @C @t dr @r:
where it is assumed, without loss of anything essential, that @r=@r is equal to 1. Evaluation of the sign of this expression requires an explicit expression for @t=@r, which represents the tradeoff, holding output constant, between the interest rate and the labor-intensity of the method of production. To obtain an expression for this tradeoff, we proceed as follows: Expression (B.4), as it stands, represents the net profitability of the contemplated investment. This will be at a maximum when a dollar of interest cost incurred to finance current production makes the same contribution to net profit as a dollar of capital embodied in investment. To get this tradeoff, we accordingly take the total differential of expression (B.4), with respect to t and r:
dN ¼
n ð1 þ rÞ X
i
h
^ 1 þ 2r @@tCi dt þ 12
i¼1
@ C^i @r
i dr i Ri 1 þ 2r C^i ð1 þ rÞi1 dr
ð1 þ rÞ2i
@C @C dt dr: @t @r (B.6)
The relationship desired is then obtained by equating this total differential to 0 and solving for @t=@r.
244
Appendix B n P 1
½Ri ð1þ2r ÞC^i ð1þrÞi1
i^ 2ð1þrÞ Ci þi
dt ¼ dr
i¼1 n P
ð1þrÞ2i ð1þrÞi
^ ð1þ2r Þ@@tCi
i¼1
ð1þrÞ2i
þ @C @r
:
(B.7)
þ @C @t
The usual presumption would be that dt=dr is negative. Inspection of the righthand side of expression (B.7), however, shows that the sign of dt=dr depends upon the sign of the denominator. Since all of the terms in the numerator are positive, the numerator will clearly be positive. In the denominator, on the other hand, we see ^ that the term in the summation contains @ C=@t, which (as has been discussed) can be assumed to be negative. The denominator, accordingly, can be negative, depending upon the size of the term in the summation in relation to @C=@t, which can ^ obviously be assumed to be positive. If @ C=@t is strong enough, the denominator can be negative, which means that dt=dr can be positive. Since the sign of dt/dr is ambiguous, it follows that the sign of @N=@r in expression (B.5) is ambiguous as well. In short, investment functions do not necessarily vary inversely with the rate of interest.
Further Discussion and Conclusions An inverse relationship between investment and the rate of interest has been a cornerstone of economic analysis for more than 200 years. While there have been occasional challenges, such as emerged during the capital controversy during the 1960s and 1970s, the possibility of an upward-sloping investment function as a practical matter has never been taken seriously. Theoretically, demand functions can slope upward as well, but the usual place that such a phenomenon is sought is in the study of potato demand in nineteenth-century Ireland. The conclusion of this paper may appear in a similar light. In my view, however, the novelty of this exercise lies not in the conclusion itself, but in the mechanism whereby the ambiguity of sign arises. Once one takes into account that capital (viewed as a pool of accumulated savings) funds not only investment but current production as well, the relationship between investment and the rate of interest becomes anything but straightforward. Interest is not only a factor in determining the cost of investment, but is also a component of the current cost of production. More capital-intensive methods of production involve lower avoidable costs of production and therefore lead to lower interest costs for “working capital.” The result, accordingly, can be an inverse relationship between the labor intensity of the method of production and the rate of interest, which is equivalent to a positive relationship between investment and the rate of interest. This result would not appear to be a reflection of reswitching, for the possible positive relationship between investment and the rate of interest depends upon the wage rate for labor. A labor-intensive method of production implies large wage
Appendix B
245
payments that have to be financed during the period of production, thereby implying a high interest cost for “working capital” when the rate of interest is high. A part of these high-interest-carrying costs can be avoided by a more capital-intensive process. The same phenomenon can obviously arise, indeed, with even greater force, in connection with the length of the period of production. A simple example will illustrate the point. Consider an earth-moving contractor whose “book of blueprints” for moving dirt includes a variety of earth-moving equipment of varying capacities per unit of time. A 20-cubic-yard machine can clearly move considerably more volume in an hour than a 5-cubic-yard machine. The larger wagon will obviously embody more capital, but it will also require less labor input because projects will take less time. The period of production will be shorter, which means that “working capital” interest costs will be smaller. In this situation, it is accordingly possible that a high interest rate combined with a high wage rate will lead to investment in the more capital-intensive machine. This example assumes that the complete method of production is up for grabs. Most of the time this is not the case, as choice will refer to investment that alters the method of production on the margin. But even so, the phenomenon adheres, for a high wage rate combined with a high interest rate can lead to capital-intensive alterations to the production process in order to economize on “working capital” interest costs.
Appendix C Implications of the Oil Price Increases of the 1970s
Introduction In the fall of 1973, the Organization of Petroleum Exporting Countries (OPEC) succeeded in quadrupling the world price of oil, with a further doubling in 1979. Economies that were heavy importers of oil almost immediately went into recession, inflation mounted, and a lengthy period of slow growth (or even stagnation) was initiated. This was especially the case in the USA. Not only did the US economy suffer both recession and inflation, but the stage was set for a slowdown in labor productivity which continued into the 1990s. Most macroeconomists see this prolonged slowdown in labor productivity as a major macroeconomic puzzle. That it seems to date from the 1973 energy crisis is more commonly viewed as coincidental than causal. The purpose of this appendix is to argue the contrary, that the OPEC-induced oil price increases were in fact a principal cause of the productivity slowdown, specifically as a consequence of a classic “transfer” problem that involved the transfer of a massive amount of real wealth from oil consumers to oil producers. While a number of mechanisms were involved in effecting this transfer, the end result necessarily and inevitably entailed a decrease in real income on the part of oil consumers. In essence, there were two ways that this decrease in real income could come about: through inflation or through unemployment. With inflation, the cut in real income would occur through goods prices increasing just a little faster than the increase in money wages, while with unemployment, the cut in real income would occur through the loss of income for those who lost their jobs. What generally is not appreciated is that real output would necessarily be reduced in either case. Moreover, the transfer involved was neither a relative price problem (although in time substitution away from energy as an input as a result of changed relative prices both could and did alleviate some of the adverse effects) nor a recycling problem.
247
248
Appendix C
Instantaneous Effects of the Oil Price Increases It is useful at the outset to separate, at least conceptually, the instantaneous effects of the OPEC-induced oil price increases from the longer-run effects. The immediate effects of a large and instantaneous increase in the price of a commodity such as oil is to transfer wealth from those who consume the commodity to those who produce it. The mechanism by which this occurs is as follows. In the very short run, production coefficients are essentially fixed, which is to say that the level of final output is essentially proportional to the amount of the (now much higher priced) commodity available for use as an input. Assuming that the price increase was unexpected, the existing pool of purchasing power would have been created in anticipation of the old price. At the new price, production must necessarily be lower (because of fixed production coefficients) than what was anticipated at the old price. Expenditures for inputs will be the same, but a much larger proportion of these expenditures will go to the suppliers of the now much higher-priced input. Receipts of other input suppliers will necessarily be lower. The initial effect, accordingly, is a transfer of wealth from these other input suppliers and producers of final goods (since there will be less output to be sold) to the suppliers of the now higher-priced input. Since labor, in the short run, cannot be substituted for this input, unemployment must inevitably arise. In the first production period following the price rise, two cases need to be considered. The first of these, which corresponds to the way Germany and Switzerland dealt with the 1973 oil price increase, is where the input price rise is contained by the monetary authority and is not allowed to affect the general price level. Accomplishing this requires restricting the new pool of purchasing power to be created to be no greater than it would have been in the absence of the price rise. Banks, in this situation, will not be able to increase the size of loans they make to their business customers in order to offset the now higher costs of production. The effect of this policy is to ratify the unemployment that the price rise initially induced. The unemployment will endure, under this policy, until such time as there is substitution away from the higher-priced input. The second case, which corresponds to the way the USA dealt with the problem, is where the monetary authority allows the pool of newly created purchasing power to increase in proportion to the higher input price. Such a policy would appear to allow production to return to its former level, but this could never, in fact, be the case. While the enlarged pool of purchasing power would enable non-oil inputs to receive the same money income as before, the higher cost of oil would obviously be translated into higher output prices. With higher output prices, but the same non-oil money incomes, not all of the old output could be purchased. Almost certainly, some unemployment would appear which, in general, would be scattered throughout the economy, rather than being restricted to the large oil-consuming industries. The amount of unemployment, however, would probably be smaller than in the first case. As in the first case, though, real incomes would, once again, necessarily be reduced.
Appendix C
249
In the first case, containing the price increase of oil through a restrictive monetary policy, the cut in real income would fall primarily on the unemployed. In the second case, in which the decrease in real income comes about through goods prices increasing faster than increases in money wages, the burden of the decrease in real income would be much more widely dispersed amongst the population. Germany and Switzerland used the first method to deal with the 1973 oil price shock by “inviting” their alien “guest” workers to quit the country. In this case, the cuts in real incomes fell on non-nationals. Had the same policy been followed in the USA, millions of aliens would have been forced to leave the country. As such a policy was obviously socially and politically unacceptable, the inflation route was followed instead. The foregoing conclusions can also be arrived at through consideration of the conservation laws imposed by the pool of fluid capital. As discussed at numerous points in the body of this book, one of these laws is that the real value of the stock of money is bounded by the goods side of the pool of fluid capital valued in current prices.1 Since an arbitrary increase in the price of oil cannot (instantaneously) increase the number of goods in the pool, the real stock of money is subject to the same bound immediately after the price increase as before. As a result, any increase in the nominal stock of money must necessarily be offset by inflation. Moreover, not only is the pool of fluid capital not increased by the oil price increase, but the pool is actually reduced in the sense that its productivity is lessened from what it was before the price increase. Suppose that, prior to the price increase, a dollar of fluid capital (valued in then current prices) would purchase one unit of oil. After the price increase, the number of units of oil that the same dollar of fluid capital can purchase will be less than one. There is, accordingly, no escaping the decrease in productivity that the transfer entails.
Some Real-Time Dynamics The discussion to this point has been in terms of the instantaneous effects of the arbitrary increase in the price of oil. With the passage of time, two forces come into play that will soften the impact of the initial reduction in productivity, namely, substitution away from the now greatly more expensive energy and a return of some of the initial transfer through both increased and higher-priced exports. Let us examine substitution first. The standard approach that economists and econometricians have followed for dealing with substitution away from energy in production is to include energy alongside capital and labor in industry or aggregate production functions. In some cases, materials are included as a separate argument as well. The problem with this procedure is that it attempts to deal, in a static framework, with matters that are inherently real-time dynamical. In this framework, 1
See Chap. 3.
250
Appendix C
adjustment to higher energy prices is assumed to occur via a substitution of “capital” (and possibly other materials) for energy in the context of an invariant production function. The problem with this framework is the assumption that the physical capital that embodies the more efficient use of energy can somehow be divorced from the “location” and “shape” of the production function. In my view, this is a completely unwarranted way of going about doing things, as the very nature of substitution involves altering the structure of the production function. Specifically unwarranted, in my opinion, is the assumption that there exists a set of parameters that are invariant to the processes of substitution.2 As time passes (and the higher oil prices are incorporated into expectations), substitution away from oil will begin to take place on the margin, as investment in new energy-conserving plant and equipment is undertaken. This investment can take many forms: retrofitting of existing plant, replacement of equipment, use of different fuels, alteration of processes, etc. As this occurs, the capacity of the economy to produce begins to recover some of the productivity that was lost initially as a result of the arbitrary increase in oil prices. However, since much energy-consuming plant and equipment is extremely long-lived, complete adjustment will take years, perhaps even decades. In the household sector, for example, a major energy-consuming appliance is the house itself, and it may take upwards of 50 years for the housing stock to turn over completely. As time passes, some of the original transfer will be returned as the OPEC countries and other recipients of the transfer increase their imports of goods and services from the oil-importing countries. This, too, will lead to a recouping of some of the productivity that was initially lost. This recouping will take two forms: (1) an increase in the amount of goods and services that are exported and (2) an increase in the nominal prices of exports as the inflation which the oil price increase initially triggered (as in the USA) permeates the prices of all goods (traded as well as non-traded). The faster the capacity to produce can be restructured to produce exports, the smaller will be the transfer.3 Similarly, the quicker that export prices inflate, the faster will be a partial return of the transfer.4
2
This criticism is obviously much broader than what is just being discussed here. A much more detailed critique of the problems involved is given in Appendix A above. 3 If the capacity to produce could instantaneously be restructured for exports and the oil exporters were instantaneously to spend all of their additional revenues on the affected country’s exports, then the transfer would, in principle, be netted out. In reality, of course, this could never happen. 4 This assumes, of course, that export prices inflate everywhere. If this is not the case, then exports of the countries not inflating will benefit at the cost of those countries that do inflate. Thus, it may have made very good economic sense for Germany and Japan to contain the oil price increases through restrictive monetary policies because of their large export markets.
Appendix C
251
Implications for Subsequent Productivity Growth While it is clear that, in time, a part of the original loss in productivity can be either recovered or made up through substitution, increased exports, and inflation, it is another matter whether permanent damage may have been done to productivity growth. In my view, a strong case can be made that some permanent damage, in the sense of a prolonged period of reduced productivity growth, has in fact occurred. This section develops the argument as to why this may have been the case. The key to the analysis, obviously, is what happens to the output/labor ratio as substitution and other forces initiated by higher oil prices are set in motion. There are three questions to be considered: 1. The type of substitution that occurs within the framework of existing technology. 2. The type of substitution that occurs with new technology. 3. The output/labor ratio in the export industries in relation to the same in the industries bearing the brunt of higher energy prices.
Substitution that Occurs with Existing Technology This is the type of substitution that conventional neoclassical analysis focuses on. The production technology is fixed, and higher relative energy prices lead to a substitution of “capital” and other inputs for energy along given isoquants. In the terminology of the Cambridge Capital Controversy of the 1960s and 1970s, higher relative prices for energy lead to the selection of a different plant from the same book of blueprints. Almost certainly, some substitution of this type occurred. However, if this were the only form of substitution, the original level of productivity could never be reattained. The reason for this is that, if labor is substituted for energy, it must necessarily be done at a lower real wage, while if “capital” is substituted for energy, one of two things would have to occur: If the substitution is labor-saving as well as energy-saving, the real wage might be higher for the labor employed, but less labor will be employed; if the substitution is both capital- and labor- augmenting, the real wage must once again be reduced. The operative constraint driving all of these conclusions is the one imposed by the pool of fluid capital on productivity. As was noted in the preceding section, an arbitrary increase in oil prices necessarily reduces the productivity of the existing pool of fluid capital in the sense that the pool can no longer support the same level of production after the price increase as before. In more conventional terminology, what the constraint implies is that even after movements along isoquants have occurred the new levels of production will necessarily lie on lower isoquants.
252
Appendix C
Substitution that Occurs with New Technology We have just seen that because of the constraint imposed by the pool of fluid capital, substitution embodied in existing technology cannot simultaneously save energy and increase output. The only way the existing pool of fluid capital can simultaneously support both a higher level of output and a lower consumption of energy per unit of output is through investment in new technology of a type which both alters the shapes of isoquants and shifts production frontiers outward. It is the latter which allows the pool of fluid capital to recover its former level of productivity. While investment in new technology will allow the pool of fluid capital to eventually recapture its former level of productivity, the productivity recovered represents only the static losses that arose from the initial transfer. There will be dynamic productivity losses, however, and these can never be completely recovered. These dynamic losses represent the potential increases in productivity that are foregone as a result of the necessity to divert investment that would otherwise have expanded the frontiers of production into substitution away from energy. Not only are the productivity gains foregone by these “pure” substitution investments effectively lost forever, but the way these losses show themselves is through a drag on real-time productivity growth, which may be quite prolonged. As was noted earlier, the stock of energy-consuming plant and equipment is both large and long-lived, and it could be decades before the “pure” substitution effects are fully worked out. Almost certainly, this was a factor in the poor performance of productivity during the 1970s and 1980s. The Output/Labor Ratio in the Export Industries As noted earlier, a part of the initial transfer should eventually be recouped through increased exports. The implications of this for labor productivity, however, will depend upon the relative labor intensities of production in the export industries and the industries in which production was initially curtailed. In general, the recoupment will be larger the less labor-intensive is production in the export industries, in relation to production in the non-export industries. The maximum recoupment would occur, of course, in a situation in which there is excess capacity in the export industries, all of the initial transfer is recycled as export demand, and all of the labor released by the curtailed production in the non-export industries is absorbed by the export industries at no reduction in the money wage rate. Recovery of the transfer through the export sector brings one additional extremely positive benefit, for much of the drag on productivity described in the preceding section need not come into play. The drag will be minimized, and possibly avoided altogether, to the extent that: 1. The initial transfer reappears as export demand. 2. There is a smooth reallocation of production from domestic to export industries. 3. The initial transfer is dissipated through higher export prices.
Appendix C
253
The reason exports are privileged is that they provide the only vehicle for escaping the negative income effect that was induced by the initial transfer. This is because the increased export demand represents, in essence, a return of the transfer. While the static losses associated with the initial transfer cannot be escaped, the real-time dynamic losses associated with “pure” substitution investment described in the preceding section will be smaller with investment in the export industries than with investment in the domestic industries. This is because investment in the export industries (whether in the form of new or existing technology) is for the purpose of expanding capacity, whereas the investment associated with “pure” substitution in domestic industries is for the purpose of producing given outputs at lower cost.
Financial Recycling It was thought by some in the 1970s that the transfer problem could be greatly alleviated, if not overcome entirely, through financial recycling. Funds acquired by OPEC oil producers would be recycled through the international banking system as loans to pay the higher cost of oil imports or, alternatively, to finance third-world economic development. That massive financial recycling occurred is evident; that it did not have the intended effect is also evident. The question I want to address in this section is whether, even in the absence of fiducial imprudence, the intended effect could ever have occurred. That is, could perfect financial recycling have solved the transfer problem? In general, the answer is no, the reason being that, short of the initial transfer returning dollar-for-dollar to those having to pay the higher oil costs, the transfer involved a massive redistribution of claims to the existing world pool of fluid capital. Initially, these claims were transferred to oil producers from oil consumers. But once the funds were on deposit at large international banks, many of the claims were then loaned to countries either already with balance-of-payment problems or wishing to finance ambitious development projects. The net result was a substantial redistribution of fluid capital from the major industrialized oil-importing countries to the world at large, with a handful of OPEC countries and the international banks functioning as intermediaries. Financial recycling did not solve the transfer problem, it simply altered the mechanisms through which the transfers occurred. If the fluid capital transferred from oil-importing countries had genuinely added to the world’s capacity to produce and generate income, then the overall productivity effect of the transfer would have probably been minor. Slow productivity growth in countries like the USA would have been offset by rapid productivity growth in countries like Brazil and Argentina. In the event, however, many of the OPEC funds that were recycled ended up financing consumption, so that much of the fluid capital that was redistributed was, in fact, consumed. The end result of the transfer was
254
Appendix C
accordingly a permanent reduction in the world’s pool of fluid capital. Consequently, not only did the donors of the transfer suffer from a drag on productivity, but so too did the world at large.
Conclusion At this point, the sluggish growth in labor productivity that the USA experienced between the mid-1970s and the mid-1990s should not be viewed as a puzzling coincidence of the oil price shocks that occurred in 1973 and 1979, but rather as a necessary consequence of those price shocks. The oil price increases involved a massive redistribution of the world’s pool of fluid capital away from the major industrialized oil-importing countries, including the USA. The redistribution necessarily reduced the productivity of the US pool of fluid capital, impelling the country into a prolonged period of slowed productivity growth as substantial volumes of investment had to be devoted to reducing the energy-intensity of production. Investment devoted to “pure” substitution led to real-time productivity losses, as investment that otherwise would have enlarged capacities to produce was diverted to reducing the cost of producing existing levels of output.
Appendix D A Program for Social Savings Reform
Although concerns with healthcare reform in the USA have, at least for the moment, pushed debate about the future funding of Social Security into the background, the latter clearly remains a problem, and will inevitably have to be addressed. The purpose of this brief appendix is to suggest a program for dealing with the Social Security problem, not only for its future funding, but with the broader issue of public involvement in retirement saving. While benefits from Social Security depend upon total contributions, these are determined by a mandated formula. Contributions are thus in essence a tax for funding those in retirement, and benefits are a transfer of income from those working. There is neither any control by the individual over their contributions nor any sense of ownership. Proposed in this appendix is a replacement of the present system of social security financing by a system of combined mandatory/ voluntary contributions that are (a) individually owned, (b) earn a time-varying rate-of-return, and (c) form a fund from which individual retirement benefits would eventually be paid. The broad features of such a scheme would be as follows:1 1. Accounts would be both individual and individually owned, but would be custodially administered by the Social Security Administration. 2. Accounts would be funded by a mandatory contribution of (say) 8% of an individual’s annual income (possibly independently of whether or not they were in the labor force), plus an additional voluntary contribution of any amount. Contributions should be tax-free.2 3. At the beginning of each year, accounts would be credited with interest at a rate equal to the previous year’s average rate on 20-year Treasury Bonds. 4. Individuals could begin drawing from their accounts (but would not be required to do so) at age 65, whether or not they were still working. A certain proportion of the account would be required to be annuitized, but the 1
The mechanics of this scheme are similar to those advanced by Keynes (1940) for curtailing the consumption expenditures of British households during World War II. 2 As should all retirement-oriented saving (IRAs, 401(k)s, etc.).
255
256
Appendix D
remainder could be withdrawn, within limits, in any way desired. A non-zero balance in the voluntary part of an individual’s account at the time of death would be heritable. The virtues of such a scheme (which obviously would have to be phased in over a period of years) would include: (1) much of the original motivation for the Social Security System as a “social safety-net” is retained; (2) accounts are individualized and made partially voluntary (but are not privatized); (3) a risk-free market return on contributions is guaranteed; and (4) most important of all, the program is selffinancing and continually funded.3
3
As discussed in Chap. 12, there remains, as always, the question of what is to be done with the savings. Any idea that contributions can be sequestered (as in the “lock box” proposed by Albert Gore in the 2000 Presidential Election) is of course fiction, as contributions are simply revenues to the government, and accordingly will be expended in one way or another. The ideal disposition, as noted in the text, would be for the government to “invest” the contributions in social infrastructure projects that add to the economy’s capacity to produce.
Appendix E Additional Tales Involving a Primitive Economy
This appendix, which was the initial Prologue to the book, presents a much more detailed and pedestrian description of the emergence of a primitive economy from an economic state of nature than is the case with the present Prologue. It is included here at the suggestion of one of my colleagues at the University of Arizona who has used it for a number of years (as did I) as introductory reading in upper division economics courses. While the content is similar to that presented in the current Prologue, it describes a greater variety of transactions – including the production of widgets! – so that students (and others) can get a better feel for how transactions, production structures, and goods become more complex as economies grow and develop. At various points in the narrative, tables are provided that tally up the amounts of fluid capital (in the form of bread) and other assets that exist at that point in the economy. These tables provide not only an accounting of the creation and destruction of fluid capital, but also the ingredients for the construction of an elementary set of National Income Accounts. Such an exercise should bring home to students in a simple, yet forceful, way the inherent arbitrariness that underlies any system of National Accounts. Decisions must be made as to what to define as income, what to include in the stock of fluid capital and the stock of produced means of production, what to define as money, what period over which to measure economic activity, the difference between stocks and flows, etc. For the most part, all of these decisions contain elements of arbitrariness. Hence, students should come to understand that there is no necessarily “right” way to measure income, GDP, etc. Imagine, as before, that there is a group of people who lived on an isolated island. The climate was mild and benevolent, and everyone lived at a subsistence level and slept under the stars. As before, the only product in the land was “bread,” which was mined by hand. There was no capital equipment. Everyone worked an 8-h day in the community mine in order to acquire an amount of bread that was just sufficient for survival. Everyone had the same productivity mining bread. People could work more than 8 h, but no one had ever previously seen a reason to accumulate a stock of
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bread. The island economy, in short, was in a “thorough-going equilibrium” at a subsistence level. This is where we pick up the story. Assume, now, that one of the inhabitants of the island, A (say), decides (for whatever reason) that he wants to live under a roof and decides to build a house. Building the house, however, will take ten 8-h days of labor, during which time he will not be able to mine his needed daily bread. In view of this, A decides to work 12 h for 20 days in order to build up a stock of bread to sustain himself during the 10 days that the house is being built. The stock of bread is created, and A proceeds to build his house. Next, assume that B, who has some artistic talent, decides that she wants to paint a picture and it will require 2 days of her time to do so. For “finance,” B decides to work four 12-h days in order to provide sustenance during the 2 days that will be devoted to the painting. Usually, people “die in the harness” on the island, but C fears that this may not be the case for him and thinks that it would be a good idea to build up a “nest egg” for use during his final days when he may not be able to work. He accordingly decides to work one hundred 12-h days, which results in a “rainy-day” fund that would provide for up to 50 days of “retirement.” Once C’s retirement stock of bread is completed, however, C sees B’s painting and tells B that he would like to buy it in exchange for 4 days of bread. B accepts C’s offer, and accordingly gives up her painting. C’s “assets” now consist of the painting, plus a stock of 46 days of bread, while B’s assets consist of 4 days of bread. Assume, next, that D–F also become concerned about retirement and work one hundred 12-h days to build up retirement funds of 50 days each. Total savings in the economy is now 200 days of bread as follows: A B C D E F
0 4 46 50 50 50
As it turns out, bread will begin to deteriorate after a while if it is not stored in a “safe.” G notices this and decides to build such a safe. The safe, however, will take 5 days to construct, so G decides to work ten 12-h days in order to accumulate the necessary “finance.” Once the safe is completed, D–F bring their stocks of bread to G to store in his safe. To each of his clients, G gives a receipt signifying how much bread is on deposit in the safe. From each client, however, G demands (and receives) an up-front charge of 1 day’s bread as a storage fee. F sees B’s painting which C now owns and offers C 6 days of bread for it. C accepts the offer. F goes to G, collects 6 days of bread from his stock in G’s safe and gives it to C in exchange for the painting. C takes the 6 days of bread that he has just gotten from F back to G for storage. G, of course, is happy to do so, gives C a receipt, but insists upon one-half day of bread as a storage fee.
Appendix E
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There are still 200 days of savings in the economy as follows: A B C D E F G
0 4 51.5 49 49 43 3.5
E sees B’s painting, which F now has, and offers 8 days of bread for it, which F accepts. E writes a note addressed to G instructing G to transfer to F 8 days’ bread from E’s stock in G’s safe. F tells G to add the 8 days of bread to his stock, which G does after deducting one-half day of bread for the service. The 200 days of savings are now owned as follows: A B C D E F G
0 4 51.5 49 41 50.5 4
H, who has just started working, decides that he, too, needs a house and approaches E for a “loan” of 10 days’ bread in order to finance the time it will take to build it. E agrees, but tells H that he must have 1 day of bread in payment in addition to the repayment of the loan of 10 days’ bread. H builds his house, and then works twenty-two 12-h days in order to satisfy his obligation to E. The “balance sheet” for the economy now looks as follows:
A B C D E F G H
Bread 0 4 51.5 49 42 50.5 4 0
Other assets 10 (house)
8 (painting) 5 (safe) 10 (house)
I, also new to the scene, decides that she, too, wants a house, but approaches G for a loan of 10 days of bread. G only has 4 days of his own bread, but notes that there are nearly 200 days of bread in his safe that is being stored for B–F. G also notes that there is no prospect that all five claimants will remove their bread from storage for at least 40 days, and decides it is safe to make I the loan from these stocks. He, too, asks for 1 day of bread for his service fee for providing the loan. I builds her house and then works twenty-two 12-h days to repay her debt of 11 days of bread to G.
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The “balance sheet” for the economy is now as follows:
A B C D E F G H I
Bread 0 4 51.5 49 42 50.5 5 0 0
Other assets 10 (house)
8 (painting) 5 (safe) 10 (house) 10 (house)
J now arrives on the scene and begins working. One day while mining his daily bread, he chances onto a lump of a pretty, lustrous, yellow metal, which he instantly becomes attached to and calls Au. He carries it with him everywhere, and one day D spots it and immediately wants to buy it. He offers J 2 days of bread for the lump, which J accepts because he thinks he knows where he can find more. D signs a note instructing G to give J 2 days of bread from holdings in G’s safe. J then asks G to store his bread, which G agrees to do for a service fee of one-half day of bread. The “balance sheet” for the economy is now as follows:
A B C D E F G H I J
Bread 0 4 51.5 47 42 50.5 5.5 0 0 1.5
Other assets 10 (house)
2 (Au) 8 (painting) 5 (safe) 10 (house) 10 (house)
F now decides that he is getting too old to continue sleeping under the stars and approaches H with the idea of buying H’s house. He offers H 11 days of bread, but H asks for 12, which upon reflection F agrees to pay. F prepares a note for G instructing G to give H 12 days of bread from F’s stock in G’s safe, which H in turn leaves “on deposit” with G, following an up-front payment to G of one-half day of bread. The total unconsumed savings of bread remains at 202 as follows:
A B C D E F G H I J
Bread 0 4 51.5 47 42 38.5 6 11.5 0 1.5
Other assets 10 (house)
2 (Au) 8 (painting) 12 (house) 5 (safe) 10 (house)
Appendix E
261
Assume, now, that K–M make appearances, each with a strong desire to prospect for Au, but in order to “finance” their enterprises they must build up stocks of savings (i.e., bread) first. Working twenty 12-h days, they each accumulate stocks of 10 days of bread. They then search for Au for 10 days, at the end of which each has ten lumps, making 30 new lumps of Au in all. Comparison of the new lumps of Au with the lump possessed by D revealed that D’s was twice as heavy. In total, therefore, there now exist 32 “light” lumps (or 16 “heavy” lumps) of Au in the island economy. The “balance sheet” for the economy is now:
A B C D E F G H I J K L M
Bread 0 4 51.5 47 42 38.5 6 11.5 0 1.5 0 0 0
Other assets 10 (house)
2 (Au) 8 (painting) 12 (house) 5 (safe) 10 (house) 5 (Au) 5 (Au) 5 (Au) 5 (Au)
Next, N comes into town. N cannot only mine bread, but also has a talent for making “widgets.” She is capable of making two in an 8-h day. She begins by working six 12h days, building up a stock of 3 days of bread. She then builds widgets for 2 days, making four in all. When K–M see N’s widgets, K and L each want to buy one, while M wants to buy two. They each offer N one “heavy” lump of Au for a widget. N accepts and gives up her four widgets in exchange for four “heavy” (or eight “light”) lumps of Au. The “balance sheet” for the economy at this point is as follows:
A B C D E F G H I J K
Bread 0 4 51.5 47 42 38.5 6 11.5 0 1.5 0
L
0
M
0
N
1
Other assets 10 (house)
2 (Au) 8 (painting) 12 (house) 5 (safe) 10 (house) 4 (Au) 1 (widget) 4 (Au) 1 (widget) 3 (Au) 2 (widgets) 4 (Au)
262
Appendix E
It turns out that the widgets are like bread and are used up in consumption. However, they really catch on, and soon other members of the population are pestering N to provide them with widgets, either at a price of one “heavy” lump of Au or (for those who do not have any Au) for 2 days’ bread. N actually prefers making widgets to mining bread, and is happy to spend her days making widgets so long as she gets at least 1 day’s bread in return (either directly or the equivalent in Au). Those without stocks of bread begin working overtime in order to “finance” their purchase of widgets. Eventually, enough Au is mined that all transactions for widgets are conducted through the medium of “light” lumps of Au. Two “light” lumps of Au are equivalent to one widget, and each “light” lump of Au is equivalent to 1 day’s bread. Finally, a couple, O and P, arrive on the island. Each of them immediately begins working 12-h days in order to build up a stock of bread that can be used to finance the construction of a house. When their stock of bread reaches 15 days of consumption for the two of them, they quit going to the mine for 5 days while they build their house. At the end of the 5 days, they have their house and an unconsumed stock of 5 days of bread. They return to working in the mine. Both of them, though, have a taste for leisure, and they feel that they would be better off if O, rather than spending 8 h mining bread, could spend that time keeping their house in order. That way they could spend all of their leisure time in play. P figures that he knows how to make a tool (a shovel) that will allow him to obtain a day’s bread in 4 h rather than eight, so that in 8 h he will be able to mine not only his bread, but O’s as well. Making the shovel takes 2 days. The shovel works, and O is able to quit going to the mine. At this point, we end our tales.
Questions and Exercises for Discussion and Analysis 1. At what point does saving first occur in the economy? When does fluid capital first come into existence? 2. At what point does exchange first occur? Could exchange occur if everyone on the island had identical tastes? 3. At what point does investment in produced means of production first occur? 4. Should the painting be treated as produced means of production? Why or why not? 5. Should houses be treated as produced means of production? Why or why not? 6. Suppose that, except for B and C, no one else on the island placed a value on the painting (i.e., were willing to trade bread for it). Could the painting still be treated as an “asset?” 7. At what point does a store of value emerge in the economy? At the end, how many stores of value are in existence? Are widgets a store of value? 8. At what point does a “bank” begin to emerge? What functions does this “bank” subsequently perform? 9. What is the “unit of account” in the economy?
Appendix E
263
10. What functions as a “standard of deferred payment?” 11. Is there a “medium of exchange” in the economy? How about “media of exchange?” 12. Which emerges first, a “store of value” or a “medium of exchange?” Must one always precede the other? 13. Is there an interest rate (or rates) in the economy? When does the payment of interest first occur? What would have to be present in order for a single interest rate to emerge? 14. Suppose that, rather than taking 2 days to make the shovel, it took 4 days to do so, but that P’s productivity was tripled rather than just doubled. Suppose, also, that O and P decided to borrow the bread needed for “finance” from F, rather than “self-financing” through a prior accumulation of bread. How much interest might O and P have been willing to pay F for the loan? How might the amount that was actually paid have been determined? 15. Are there any myros recovery charges in the economy? Should there be? For whom would they be relevant? 16. Are there prices in the economy? If so, at what point do they first emerge? 17. Construct a table that describes the price structure for the economy at the end of the story. 18. How might a general price level be defined for the economy? 19. Construct a final “balance sheet” for the economy. 20. Construct a table describing the level and changes in the stock of fluid capital. 21. Devise a simple set of National Income Accounts for this economy. 22. Should G’s fee for storing bread be treated as income or a transfer payment? 23. When B sells her painting to C, should the bread received in payment be treated as income? What about when C sells the painting to F? Should the “capital gain” that C receives in the transaction be treated as income? Why or why not? (In thinking about this question, be sure to take care to distinguish between individuals and the economy as a whole.) 24. How should O’s “work at home” be treated in the Accounts? 25. Note that the Au of K–M is “valued” at 1 day of bread per lump, rather than two. Why is this? If it were two, rather than one, what “theory of value” would thereby be implied?
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Index
A Ability-to-pay, 27 Accounting, capital, 123–126 Accumulation, long-run, 164 Aggregate demand, 3, 28–30, 34, 47, 53, 67, 70, 72, 75–77, 104, 108, 167, 168, 172, 173, 180, 200 expenditure, 28, 103 supply, 3, 28–30, 69, 70, 72, 75, 77, 78, 104, 167, 168, 172, 180 Aggregate wealth, 23, 24, 79–80, 195, 196 fluid capital pool and, 24–27, 29, 30 Assets capital, Keynes’s attributes of, 35 deflation of prices of, 74 excess monetization of, 24, 67, 87–88, 92 residual (reservation) demand for, 25, 26 supply of, 204–205 validation of, consumption hierarchy in, 159, 168 valuation of, 25, 26 value of, 25–27 value of, capital, 27, 39, 58, 70–74, 79–102, 104, 117, 118, 120, 124, 126, 133, 244 as wealth, 79–80 B Bank, central creation of money by, 40, 42 emergence of, 203–204 monetization of fluid capital by, 36, 37, 68, 75, 92, 99, 100
stability of, 182 Banking disease, 191–193 Banking principle, 191–193 Basis (shift in confidence), 205 Bohm-Bawerk, on capital theory, 118–119 Bonds government, 40, 45, 62, 199, 220 vs. holding money as asset, 37, 40, 42 prices of, 25 Borrower’s risk, 184, 185, 187, 204, 209, 213–216 Borrowing, business, money created by, 38 C Capital. See also specific types, e.g., Fluid capital accumulation of, incentives for, 32 concepts of, 3, 7–9, 113, 115, 117, 118, 124, 176, 177 concepts of, standard, 196 as embedded (stored) labor, 120–121 financial, 8, 9, 124, 137, 146, 151, 225 financial, primitive example of, 8, 9, 124, 137, 146, 151, 225 fixed vs. fluid components of, 10 labor and, 105, 238 marginal efficiency of, 54, 103, 104, 116, 163, 182, 238 in neoclassical model, 3, 164 nonrenewable natural resources and, 126–127 in production, 10, 49 (see also Investment, production and)
271
272 Capital accounting, 123–126 Capital accounts, 88, 89, 125, 126, 133, 134, 151 Capital, fluid. See also Conservation principles; Myros as aggregate wealth, 79 conservative nature of, 123 constraints imposed by, 153, 157, 167, 175, 177, 206 definition of, 2 demands on, 20, 33, 41, 44, 76, 174 economy’s assets and, 23, 24, 171, 174 financing production with, 167 hierarchical nature of, 159–160 money and, 218 size of, 32, 38, 80, 143, 175 two sides of, 2, 8, 19, 75, 97, 113, 192, 195 Capital gain, as income, 84 Capital gains tax, 83–85, 93 on collectibles, 79, 81, 88, 157 Capital goods, vs. consumption goods Capital, human, 12–13 depreciation of, 12 Capital levies, 137–139 Capital markets, macroeconomic model of, 180 Capital, physical (real), 50 primitive example of, 159–160 Capital pool, constraints from. See Conservation principles Capital, sunk, 12, 14, 49, 162 Capital theory Bohm-Bawerk on, 118–119 as economics of time, 123 Fisher on, 117–118 Jevons on, 119–120 Keynes on, 116–117 Schumpeter on, 113–116, 137, 176 Solow on, 122, 123 Wicksell on, 119–120 Capital value of assets, 35, 193 Fisher on, 117–118 Capital, working demand for, 33, 34 primitive example of, 159–160 Carry trade, 197, 214, 220 Cash-balances equation, Marshall’s, 43, 49 “Casinos with banks,” 178, 206, 208, 218, 225, 229 CDOs. See Collateralized debt obligations CDSs. See Credit default swaps Claims, 2, 8, 9, 13, 14, 18–25, 31, 33, 37, 38, 45, 48, 68, 76, 83, 85–87, 91, 94, 96–98,
Index 103, 113, 114, 117, 120, 137–139, 146, 147, 149, 154, 156, 157, 171, 175, 191, 195, 197, 198, 210, 216, 222, 249, 253 CMOs. See Collateralized mortgage obligations Collateralization, of loans, 73 Collateralized debt obligations (CDOs), 222 Collateralized mortgage obligations (CMOs), 222 Collectibles capital gains tax on, 83–85, 93 as position goods, 27, 83, 88, 155–157, 160, 174 as store of value, 27, 157 Commercial banking, 100, 225, 227 Commercial paper market, 19, 46–47, 198, 222 Commodity money, 36, 94–95 Confidence business, 48 consumer, 48 investor, 99 vs. trust, 192, 221 Conservation principles equilibrium implications of, 75, 77, 80 myros and, 4 Constraints, from capital pool. See Conservation principles Construction horizon, 49, 57 Consume, propensity to, 91, 158, 200, 229 Consumer confidence, 48 Consumer goods vs. capital goods, 86, 87, 139 Consumption hierarchy, 159, 168 limitations on, 155 macroeconomics of, 1, 153–155 position goods, 156 real-time, modeling of, 234–237 retirement, 19, 153, 155 Cost(s) capital, 56, 57, 59, 60, 130, 131, 133, 134 definition of, 7 long-run marginal, 52, 121, 130–132 opportunity, 7, 8, 26, 63, 129–132, 134 short-run avoidable, 49, 54, 130–132 short-run marginal, 49, 51, 52, 55, 56, 58, 59, 71, 106–108, 110, 130 sunk, 129–134 unit incremental, 131–132 Covariance, 209, 210 Credit default swaps (CDSs), 215, 217, 222 Credit, money and, 47–48 Crop failure, 167, 168 Crowding-out, 89–92
Index D Debt, national burden of, 92–93 Default, loan, stock of money and, 47–48 Deficit, government financing of, 46–48, 89–93, 137, 189, 201, 220 Deflation, economic growth with, 101–102 Demand aggregate, 3, 28–30, 34, 47, 53, 67, 70, 72, 75–78, 104, 108, 167, 168, 172, 173, 180, 200 for assets, 194, 224 for current production, 46, 69, 225 on fluid capital pool, 11, 17–20, 22–27, 30, 32, 33, 36, 38, 39, 41, 45, 46, 48, 51, 58, 62, 63, 67–77, 79–88, 90–92, 94–104, 110, 113, 115, 117–119, 195, 206, 210, 211, 213–216, 221, 222, 224, 240, 244, 247 for labor, 51, 106, 108, 149 law of, 4, 232 macroeconomic model of, 2, 17–30, 103–111 for money, 45, 71 for money, business vs. household, 44 residual (reservation), 25, 26 for working capital, 33 Demand systems, theoretically plausible, 232, 235 Demonetization, of economies, 98–100 Depreciation economic, 11, 121, 124, 125, 127, 174 fiducial vs. economic, 11, 121, 125–127, 174 of human vs. nonhuman capital, 12–15 Derivatives, 4, 50, 209, 214, 217–218, 225, 240 Disasters, natural, on economic growth, 91 Dividend, social, 13, 21, 24, 63, 98, 113–115, 185, 188, 189, 224 Drivers, economic, 153, 157, 165, 166 Dynamics, real-time, 231, 233–237, 245–246, 248 E Earnings, retained, 11, 18–20, 46, 63, 184, 188 Eastern Europe, monetization of economies of, 98, 137, 138 Econometric model, from neoclassical theory, 237, 238 Economic analysis, theory in, 231–232, 237–238. See also Economic theory Economic development, 1, 114, 161, 163, 168–169, 248 Economic drivers, 153, 157, 165, 176
273 Economic growth definition of, 162 disasters in low-income economies on, 167–168 endogenous nature of, 164–165 mechanics of, 161–163 potential rate of, 175, 176 stages of development and, 168–169 technological change in, 162, 165–166 Economic state of nature, 86, 89, 251 escape from, 86, 89, 163 Economic theory of consumer choice, 232–234 laws of, 232, 235, 237 Mirowsky on, 231, 232 neoclassical vs. statics/comparative dynamics, 231 in real-time dynamics modeling, 231, 234–237 Economy evolution of, 124, 176 primitive, 1, 9, 159, 251–256 (see also Primitive economy) Employment, equilibrium and, 103–111, 114, 171, 172. See also Equilibrium Engel curves, 157–159 Engel schedules, 233 Enterprise, 120, 148, 193, 194, 197, 205, 208, 209, 214–217, 254 Equation of exchange, 3, 65–68 Equilibrium circular flow, 114, 116 in rates of interest, 76–78 Equilibrium, employment and Garegnani on, 104, 105 Haberler-Pigou-Scitovsky wealth effect and, 103 Keynes on, 103, 104 Equities, 24–27, 45, 62, 63, 81, 82, 139, 141, 142, 147, 148, 184, 185, 194, 197, 198, 205, 206, 223, 225, 228 Europe, Eastern, monetization of economies, 98, 137, 138 Exchange rates, trade and, 135–137 Expenditure, aggregate, 28, 103 F Federal Funds Rate, 45 Fiat money commercial paper market and, 46 creation of, 41, 42 real-balance effect on, 27, 110 Fiducial structure, 19
274 Finance in economic activity, 36 motive, 21, 36–38, 45, 62, 116, 117 as revolving fund, independent of saving, 117 Financial circulation, 206, 210, 222 Financial panics, anatomy of, 203–208 Financial recycling, 248–249 Financing. See also Investment of current production, 2, 19, 30, 38, 39, 41, 44, 46, 47, 51, 52, 68, 70, 73, 75, 95, 96, 117, 143, 174, 214, 225, 227, 240 hedge, 186–187, 189, 209, 214, 215, 225 of investment, 62–63 Ponzi, 87, 186–187, 189, 213, 215, 216, 226 speculative, 186–187, 189, 209, 210, 213, 215, 216, 225, 226 Firms, 25, 106, 186, 190, 204 Fiscal policy, role of, 199–201 Fisher, Irving, on capital theory, 117–118 Fix-price, 188–190 Flex-price, 188–190 Flows, 9, 19, 20, 24, 26–28, 32, 42, 52, 53, 69, 70, 72, 74, 75, 79, 84, 85, 114–117, 119, 125, 137, 172, 182–185, 187, 189, 191, 192, 194, 197, 204, 213, 219, 251 Fluid capital. See Capital, fluid Fungibility, 10 of human vs. nonhuman capital, 12–13 G General price level equilibrium in rates of interest and, 76–78 excess monetization in, 72–75 Fisher on, 65–69 as meaningful concept, 14 natural rate of interest and, 75–76 price determination and, 71–72 German reunification assessment of, 150–151 monetary integration in, 146 monetary overhang in, 137–139 monetary overhang in, elimination of, 146–150 privatization process in, 147, 148, 150 wealth transfer in, 139–145 Glass Steagall Act, 225, 227 Gold standard, fluid capital and, 95–98 Gold, value of, 94, 95, 97, 216 Goods definition of, 13 luxury, 158
Index in poor vs. wealthy economy, 137, 159, 168, 169 position, 27, 83, 88, 155–157, 159, 160, 174 as value, 95, 136, 157, 171, 175 Government deficit, financing of, 90 Growth economic (see Economic growth) potential rate of, 175, 176 H Haavelmo paradigm, 235, 236 Haberler-Pigou-Scitovsky wealth effect, 103 Hedge finance, 186–187, 189, 209, 214, 215, 225 Hedge funds, 197, 198, 206, 209, 210, 214, 215, 217, 218, 221, 225–227 I Income capital gain as, 83–85 definition of, 13 elasticities, 157–159, 161, 173, 176 Fisher on, 117 generation of, 43 as monetized purchasing power, 68, 70 as value of current production, 8, 22–23, 68–70, 75 Income equation of exchange, 66 Inflation in asset prices vs. goods, 74, 87 cause of, 39, 42 cost-push, 71 demand-pull, 69, 70 general price level and, 65–72 (see also General price level) as monetary phenomenon, 70 on money as a store of value, 42 money supply growth and, 175 origins of, 29 from wealth transfer, 141–143, 145, 147 Inside-money world, 39, 41 Interest, money and. See also Interest, rate of commercial paper market and, 46–47 factors in determining, 33–41 fiat money and, 41–42 monetary authority in, 45–46 velocity and demand for money in, 43–44 Interest, rate of discount, 45, 54, 57, 182, 183, 239 existence of, 32–33 Federal Funds, 45 fiat money and, 41–42
Index investment and, 31, 54, 55, 105, 174, 238–241 in Keynes’s General Theory, 31 Liquidity Preference vs. Loanable Funds, theories on, 31 long-term, 45, 77 monetary authority, effect on, 45–46 own-rates of, 35, 41, 42, 193 short-term, 44, 45, 77, 205, 220 Interest, rate of, money determination of, 20, 33–41 equilibrium in, 76–78 government financing, effect on, 41–42 importance of, 36 in investment decisions, 62 in Keynes’s General Theory, 34–35 liquidity preference in, 37, 38, 40, 41, 46, 76 Interest, rate of, natural definition of, 14 determination of, 20, 21, 33–41 equilibrium in, 76–78, 90 general price level and, 75–76 government financing, effect on, 41–42 in production and investment, 41, 61, 62 Internal rate of return, 54, 81 Investment. See also Financing definition of, 13 forced saving and, 85–87 funding for, 1, 2, 86, 87, 92, 93, 162, 178, 241 interest rate and, 103, 105, 174, 239–242 pace of, 176, 183–186, 201 private, public borrowing vs. taxation, effect on, 93 in produced means of production, 2, 8, 10, 12, 18, 19, 21, 22, 30, 33, 34, 37, 41, 46–48, 52, 53, 63, 73, 76, 78, 81, 82, 90–92, 95, 96, 98, 106, 119, 124, 125, 139, 153, 155, 161–163, 169, 174, 178, 182, 188, 197, 206, 211, 225, 227, 239, 240, 256 public, 90–92, 94, 164, 222 in research and development, 166, 176 saving and, 19, 23, 27, 30–32, 34, 62, 78, 81, 86, 89, 103, 110, 117, 120, 122, 124, 145, 169, 171, 172, 176, 211 socialization of, 164 Investment banking, 225, 227 Investment decision on construction-work-in-progress, 58 on new projects, 205
275 reason for, 5 risk and uncertainty in, 54 simplified view of, 53 willingness-to-pay in, 53, 54 Investment horizon, 49, 54, 81, 124, 183, 187, 239 Investment, production and capital in, 49–52 capital in, fluid, 52 decision on, 53–58 (see also Investment decision) financing of, 62–63 rates of interest in, 61–62 J Jevons, on capital theory, 119–120 K Keynes on capital theory, 116–117 rebuttal of Viner, 179, 180, 192, 201 on stable economic growth, 163–164 Keynes’s General Theory demand for money in, 36–37 interest rate in, 31 liquidity preference in, 31, 32, 37, 40, 182 money as a store of value in, 39, 181, 223 Keynes’s identity, 23 L Labor capital and, 103–105, 126, 162, 238, 245, 247 demand for, 106, 108–110 embedded (stored), capital as, 120–121 market, of economy, 108, 109 Law of demand, 4, 232 Laws, in economics, 1, 4, 77 Lender-of-last-resort (LOLR), 196–199, 219–220, 224, 226 Lender’s risk (LR), 39, 184–187, 193, 204, 205, 209, 213–215, 217, 219, 229 marginal (MLR), 184, 186 Liquidity preference in money rate of interest, 37, 38, 40, 41, 46, 76 theory of, 4, 31, 182 Tobin and Shackle on, 37, 182 Liquidity premium, 35, 37, 40–42, 76, 77, 182, 192, 193 Loanable Funds theory, 31 Loan defaults, stock of money and, 88–89
276 LOLR. See Lender-of-last-resort Long Term Capital Management Fund, 198, 210 Luxury goods, 158 M M1, 47, 222 M2, 222 Macroeconomic equilibrium. See Equilibrium Macroeconomic framework aggregate demand and supply in, 28–29 asset values in, 17, 23–27, 48 constraints/conservation laws in, 17, 22–24 equilibrium in, 22, 29–30 overview of, 17–22 M2 and M3, 47, 48 Marginal lender’s risk (MLR), 184–186 Market-clearing price, 25, 26, 34, 67, 69, 70, 75 Marshall’s cash-balances equation, 43 MLR. See Marginal lender’s risk Monetary authority, 3, 37, 44–46, 116, 143, 226, 227, 243, 244 Monetary economy, 2, 8, 36, 42, 75, 98, 211, 227 Monetary overhangs in German reunification, 150–151 in German reunification, elimination of, 146–150 wealth transfers and, 139–145, 150 Monetary policy, 3, 37, 47–48, 220, 224, 244 Monetization by banking system, 23, 36, 45 definition of, 14 of economies, 79, 98–100 excess, of assets, 72–74, 87–88 Money. See also Myros commodity, 9, 23, 35, 36, 94–95 confidence and, 48, 94, 95, 100, 177, 178, 192, 203, 223, 226, 227 creation of, 19, 29, 31, 38–40, 42, 46, 47, 73, 76, 87, 88, 100, 101, 117, 175, 176, 178, 195, 216, 222, 225, 227 creation of, business borrowing in, 38 credit theory of, 113 definition of, 14, 23 demand for, 22, 36, 38, 40, 41, 43–44, 219 demand for, business vs. household, 43, 44 fluid capital and, 33, 36, 210, 211, 251 forms of, 96 macroeconomic theory of, 19–30 material role for, 20, 75 as medium of exchange, 22, 23, 35, 39, 42, 47, 94, 181, 193, 210
Index primitive example of, 9 in production and investment, 44, 47, 48, 61–62, 96 as social invention, 2, 14, 23, 94, 172, 176, 223 stock of (M), 2, 3, 23, 26, 36–40, 43, 47, 62, 65–68, 71–73, 75, 80, 88–91, 93, 95, 98, 103, 104, 110, 111, 116, 118, 120, 139, 141–143, 145, 146, 148, 168, 171, 173, 175, 196, 197, 209, 210, 213, 215, 223, 244 stock of (M), loan defaults and, 88–89 as store of value, 24, 39, 42, 94, 177, 178, 181, 182, 196, 197, 199, 203, 223 as wealth, 80 Money, fiat (government) commercial paper market and, 46–47 creation of, 3, 41, 42 real-balance effect on, 27, 80, 103, 104, 110, 111, 171 Money market, 4, 46, 199, 204, 205, 214, 220, 225–227 macroeconomic model of, 20, 22 Myros. See also Money barter vs. monetary economy and, 8 vs. capital, 8–10, 12–13 creation of, 9, 12 definition of, 13–15 as fluid capital, 10 fundamental role of, 1 goods and claims side of, 2, 8, 9, 19 primitive example of, 9 saving of, 2, 13 Myros recovery charges definition of, 13 in macroeconomic model, 1, 19, 20, 25, 30 N National debt, burden of, 92–93, 175 National disasters, on low-income economies, 167–168 National resources, nonrenewable, capital and, 126–127 Nature, economic state of escape from, 86, 89, 163 Neoclassical general equilibrium theory problems with, 22, 23 Neoclassical model, problems with, 3 Neoclassical theory, econometric models from, 237, 238 New Classical Model, 179, 180 New Growth Theory, 176 New Keynesian Model, 179, 180
Index Non-Acceleration Rate of Unemployment (NAIRU), 175, 176 Novelty, quest for, 158, 165, 166 O Oil price increases financial recycling in, 248–249 instantaneous effects of, 243–245 real-time dynamics of, 245–246 on subsequent productivity growth, effects of, 246–248 Old Masters, 14, 24–27, 35, 79, 81–85, 94, 97, 139, 156, 157, 159, 167, 168, 174, 175, 193. See also Collectibles as store of value, 24, 26, 81–83, 94, 139 Own-rates of interest, 35, 193 P Payback horizon, 11, 58, 131 Plant, sunk costs of, 132–134 Ponzi finance, 187, 189, 215, 226 Population, 17, 100, 140, 142, 145, 146, 148, 156, 169, 229, 235, 244, 255 Position goods, 27, 83, 88, 155–157, 159, 160, 174 Present value, 27, 54, 57, 58, 83, 84, 106, 117, 118, 121, 122, 125–127, 131–133, 179, 182, 183, 187, 189, 196, 204, 239 Price index, 65, 72, 221. See also General price level Prices general, 14, 23, 28, 29, 65–78, 87, 90–92, 95–102, 104, 141–143, 145, 153, 172, 173, 175, 243 (see also General price level) relative, 99–102, 104, 105, 173, 243, 247 Primitive economy balance sheets of, 253–255 banking system in escapes from myros in, 1 new currencies in retirement savings in, 9, 252 saving in, 252, 254 Production capacity, 18, 55, 149 capital-labor tradeoff, 105, 238, 239 current, demand for, 69 produced means of, 2, 8, 10–15, 17–20, 24, 25, 28, 32, 33, 35, 36, 45, 49–55, 63, 73–75, 82, 83, 86, 87, 98, 99, 105, 106, 118, 119, 124, 125, 140–142, 144, 147,
277 148, 150, 161–163, 165, 172, 204, 211, 227, 239, 240, 251 produced means of, investment in, 2, 8, 10, 13, 19, 21, 22, 30, 33, 34, 37, 41, 46–48, 53, 63, 73, 76, 78, 81, 82, 90, 92, 95, 96, 98, 106, 119, 124, 125, 139, 153, 155, 161–163, 169, 174, 178, 182, 188, 197, 206, 211, 225, 227, 239, 256 short- and long-run costs of, 51, 52 Production, investment and capital in, fluid, 52 decision on, 53–58 (see also Investment decision) financing of, 62–63 rates of interest, effects of on, 61–62 Productivity growth, effects of oil price increases on, 246–249 Public investment, 90–92, 94, 164 Purchasing power, current pool of, 29, 104, 172–173 Purchasing power parity, 136, 137, 142, 150 Q Quasi-rents, 11–14, 20, 25, 52, 58–61, 63, 73, 82–84, 92, 106–108, 118, 119, 121, 124–126, 130–134, 156, 166, 174, 182, 183, 185, 186, 200, 204, 206, 215, 239 burdens of, 188–190 R Rational Expectations Revolution, 179 Real-balance effects aggregate, 80, 104, 110, 111, 171 money as wealth and, 27, 80 reverse operation of, 111 on stock of fiat money, 27, 80, 103, 104, 110 Real Bills Doctrine, 38, 175, 227 Real-time dynamics modeling of, 231, 234–237 of oil price increases, 245–246, 248 Redundancy, 158 Relative price, 99–102, 104, 105, 173, 243, 247 Research and development, investment in, 166, 176 Resources, permanent, 17, 18, 32, 50, 124, 126 Retirement consumption, 19, 153–155 Retirement saving, 9, 153–155, 250 Ricardian equivalence theorem, 93–94 Risk, in investment decisions borrowers’, 186, 187 lenders’, 186, 187 Risk premium, 54
278 S Saving as deferred consumption, 120 definition of, 13 forced, 70, 85–87, 114 forced, investment and, 85–87 incentives, 32, 145, 164 investment and, 23, 27, 30– 34, 52, 81, 85–87, 89, 103, 104, 110, 117, 120, 122, 124, 139, 169, 171, 172, 176 (see also Investment) macroeconomics of, 23, 153–155 negative, 19, 31, 33, 220 retirement, 9, 19, 153–155, 250, 252 social, 153, 154, 249–250 Schumpeter on capital levy, 135, 137–139 on capital theory, 113–116 Social dividend, 13, 21, 24, 98, 113–115 Social saving, 153, 154, 249–250 Social security, 93, 154, 155, 249, 250 Solow, Robert, on capital theory, 122, 123 Speculation, 146, 178, 193, 194, 197, 205, 206, 208–210, 215, 216, 221, 224, 226, 227 Speculative finance, 187, 189, 209 Spot price, 53, 55, 184, 194 Statistical inference, 235, 237 Stocks, 2, 3, 8–10, 12, 14, 15, 19, 23, 24, 26, 28, 32–34, 36–45, 47, 48, 50, 51, 55, 62, 65–73, 75, 79, 80, 82, 83, 86–93, 95–99, 103–105, 110, 111, 114–120, 122–125, 136–143, 145–149, 154, 162, 168, 171–175, 194, 196, 197, 204, 205, 209–211, 213–216, 223, 224, 244, 245, 247, 251–256 Structural change, 235, 236 Sub-prime mortgages, 177 Substitution with existing technology, 246–247 with new technology, 246, 247 Sunk capital, 10, 11, 14, 19, 32, 52, 58 Sunk costs, 129–134 Supply aggregate, 3, 17, 28–30, 69, 70, 72, 75–78, 104, 167, 168, 172, 180 of assets, 20, 25, 26, 204–205 macroeconomic model of
Index T Taxation, of capital gains, 79, 83–85 Technological change, in economic growth, 162, 164–166 Time, economics of, 121–123 Trade, exchange rates and, 97, 100, 135–137, 150 Transfers. See Wealth transfers U Uncertainty in investment decisions, 54 as a psychological phenomenon, 213 vs. risk, 4, 48, 54, 81, 178, 198, 214, 227 Unit incremental cost (UIC), 131–132 V Value. See also Assets; Capital; Money of assets, 25–27 capital, Fisher on, 117–118 capital, of assets, 27, 39, 58, 70–74, 79–102, 104, 117, 118, 120, 124, 126, 133, 244 collectibles as store of, 79, 81, 157 of fluid capital, aggregate, 23, 24, 95–98 of gold, 94, 95, 97, 216 goods as, 95, 136, 157, 171, 175 money as store of, 39, 42, 177, 178, 181, 182, 196, 197, 199, 203, 223 of production, income as, 171 Velocity, 43–44, 66, 96, 222 W Wagering, 178, 193, 194, 205–211, 215, 216, 221, 224–227, 229 Walrasian general equilibrium models, failure of, 23 Wealth aggregate, 23, 24, 79–80, 195, 196 definition of, 15 Fisher on, 117, 118 money as, 80 Wealth transfers in German reunification, 139–145, 150 from oil consumers to oil producers, 243 Wicksell, on capital theory, 119–120 Willingness-to-pay for existing assets, 85, 183 in investment decision, 53, 54, 182
