Monday, June 6, 2011

Economic Recovery, Part III: America's Capacity to Consume (1)

In the previous posting in this series, we looked at the role production plays in restoring equilibrium to a market — the first "half" of Say's Law of Markets." To summarize very briefly (go back to the June 2 posting for a more extended treatment), Say's Law is that production equals income. Thus, if there are goods that remain unsold, other goods must be produced in order to generate the income that can be used to purchase the otherwise presumably "excess" goods.

Thus, Dr. Harold Moulton, following up on his work in America's Capacity to Produce (1934), could state in 1936 that one of the keys to economic recovery was increased production. Consistent with the other "half" of Say's Law of Markets," and given the shift away from small ownership to the wage system that characterized the 20th century, Moulton assumed that the other key to economic recovery was employment. As he explained,

"Production and employment are basic and ultimate points of reference in modern industrial life. Depression, like prosperity, is a phenomenon which is significant primarily in these terms, and no understanding of the factors of recovery may be gained without a thorough consideration of these two elements of economic activity." (Harold G. Moulton, The Recovery Problem in the United States. Washington, DC: The Brookings Institution, 1936, 114.)

Thus, without both production and consumption somehow tied together, there will be no true and lasting economic recovery. The facts of economic history are clear:

The U.S. was only able to come out of the first Great Depression (1893-1898) due to crop failures in Europe at the same time there were bumper crops in the United States. Fortunately, while there were increasing numbers of people dependent on wages alone for their income, the majority of Americans still lived on family-owned farms. The benefit of the increased production and sales of agricultural products went directly to the owner, who was also the worker, who naturally spent the income on consumption. This generated the effective demand needed to pull the country out of the first Great Depression without government intervention.

The U.S. was only able to come out of the second Great Depression (1930-1940) due to the increased demand for war material needed for the Second World War. This created large numbers of wage system jobs, giving the illusion that the State could somehow both mandate and create "full employment," but also generating the effective demand needed to pull the country out of the second Great Depression.

There were two problems with the recovery from the second Great Depression. One, the workers engaged in production of war material did not, in general, own the capital that was responsible for the bulk of production. Consequently, the income generated by capital did not go to workers who would use it for consumption, but to owners of capital who used it for reinvestment in additional capital.

Two, to finance the war the politicians used the politically popular debt financing that almost destroyed the Union during and after the Civil War, instead of unpopular taxation. Ironically, although cited as the authority for using debt instead of taxation, Keynes saw this as a serious mistake, as even within his badly flawed paradigm, increasing the money supply once full employment has been reached can destroy the economy through "real" inflation.

Using debt instead of taxes to finance the war effort, however, convinced "post Keynesian" economists and politicians that the deficit or the total outstanding debt doesn't matter. This creates a serious problem in the financial system.

Under the "Currency Principle," "money" is defined as coin, currency, demand deposits and selected time deposits. It represents claims on the present value of existing marketable goods and services in the economy. Thus, under the Currency Principle, the fiction is that all a country is doing when it inflates the currency, whether by monetizing its deficits by selling securities to the central bank, or issuing the currency directly (there is no substantial difference between the two, as Keynes recognized), is dividing up the existing pie into smaller and smaller pieces.

The reasoning appears to be that this is not a problem, for the outstanding debt is simply demands on existing goods and services. To eliminate the debt, all that is necessary is to print more money to pay it off, thereby shifting the debt further in to the future. If immediate payment is demanded, raise taxes and secure enough of the existing pool of wealth to satisfy immediate demands.  To get out of debt, cut spending.

Unfortunately, this reasoning does not hold up under scrutiny. "Money" is not just State-issued or authorized claims on existing marketable goods and services. No, money consists of anything that can be used to settle a debt. This includes claims issued by both the State and the private sector not only on existing, created wealth, but on future, uncreated wealth, that is, the present value of marketable goods and services to be produced in the future.

We will look at how this misunderstanding of money has led to the present situation in which governments have created outstanding debts far beyond their ability to repay — an impossibility in Keynesian economics.

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