Wednesday, October 15, 2008

Reaching Bottom with the Washington Post

Do squeaky wheels ever get greased? Stay tuned, and we'll find out. We've been letting the Washington Post off the hook for a while, but today's edition had a well-written and insightful column by Steven Pearlstein that was, unfortunately, based on a disproved Keynesian dogma: that capital can only be formed out of existing accumulations of savings. Fortunately, we're working on getting out a new edition of Dr. Moulton's book, which should prove invaluable to people like Mr. Pearlstein, and help the powers-that-be start using money, credit, and banking as designed and intended.

Dear Sir(s):

While I agree with Steven Pearlstein that we have yet to "reach bottom" in the financial crisis ("Buckle Up — We Haven't Reached Bottom Yet," Washington Post, 10/15/08, D1), his analysis of what is needed for recovery is based on an incomplete understanding of money, credit, and banking, as well as the process of capital formation. Contrary to Mr. Pearlstein's implicit assumption, we do not need to cut consumption and save before investing. This is a Keynesian dogma disproved by Dr. Harold Moulton of the Brookings Institution in his 1935 monograph, The Formation of Capital.

Mr. Pearlstein is absolutely correct that, should matters proceed along Keynesian lines, the already-weakened financial system will only get weaker. The solution, however, is not to bite the bullet and cut consumption. Rather, we need to reorganize the financial system along more rational lines to enable more people to realize Keynes' "effective demand" without the need for the government to create more debt-backed currency with its consequent inflation.

Commercial and central banking (as opposed to "deposit banking") were invented to allow people to obtain credit and finance capital formation without first saving. Keynes, however, dismissed the idea that money could be created through the banking system to finance industrial, commercial, and agricultural projects that would pay for themselves out of future earnings. This is a process called "forced" or "future" savings. Keynes believed that only the State could create money in this way, backed by debt instead of assets, to redistribute wealth and thereby generate effective demand.

Dr. Moulton demonstrated that demand for capital ("investment") follows consumer demand; that from 1830 to 1930, periods of increased investment were preceded in every case not by saving — cuts in consumption — but by increases in consumption! The money to finance new capital formation in response to the increased consumer demand did not come from existing savings, but from the extension of bank credit for investment in sound capital projects.

Further, Dr. Moulton proved that by cutting consumption in order to finance economic recovery, recovery is actually slowed, if not halted altogether, as in the "mini-depression" of 1936-37 when the false stimulus of inflation and currency devaluation started to wear off. The real increase in effective demand caused by the war in Europe, not the artificial demand created by the Keynesian programs, brought America out of the Great Depression.

Do we need a war to bring us out of the current crisis? No. We need simply create money for capital formation in ways that make new owners of that capital out of people who previously owned little or nothing in the way of income-generating assets. These new owners will use the income from their capital first to force savings to repay the acquisition cost (a process called "self-liquidation"), and then use the income for consumption, not reinvestment. This will generate real effective demand instead of the "phony" effective demand of inflation.

A program to achieve this much more rational goal is called "Capital Homesteading for Every Citizen," from the book with the same title. It is well worth considering when the alternative is more of the same, only worse.

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