Tuesday, May 9, 2017

2. The Formation of Capital


One of the conundrums of a modern economy is how to restore Say’s Law of Markets so that consumption and production are in balance.  What makes the problem worse is the fact that the mainstream schools of economics, Keynesian, Monetarist/Chicago, and Austrian, take for granted an assumption that flies directly in the face of Adam Smith’s first principle of economics stated in The Wealth of Nations: “Consumption is the sole end and purpose of all production.”
Irving Fisher (1867-1947)
While this point seems obvious, most modern economics assumes as a given that production is only partly for consumption.  They think the purpose of production is also to accumulate excess production that is saved in order to finance new capital formation.  The bottom line is that, in modern economics, the purpose of production is consumption and more production.
Producing for both consumption and reinvestment for more production throws a monkey wrench into the economic machine.  Dr. Harold G. Moulton explained why when he analyzed Dr. Irving Fisher’s formulation of the Quantity Theory of Money equation,
M x V = P x Q
where M is the money supply, V is the “velocity” of money (the average number of times a unit of money is spent during a period), P is the price level, and Q is the number of transactions.
It seems that Fisher made a few mistakes in trying to apply his own formula.  First and foremost, Fisher assumed that “money” referred only to currency and “currency substitutes” such as checks, credit cards, and debit cards (the latter two didn’t exist in Fisher’s day, but even he would agree that they are used in lieu of cash).
As Moulton pointed out, the money supply consists of anything that can be accepted in settlement of a debt.  Not accounting for the bulk of the money supply means that decisions affecting monetary and fiscal policy are going to be based on very bad data, and will almost inevitably be wrong.
Another point Moulton made was that Fisher’s analysis included only consumer goods in the number of transactions, distorting the results even more.  Moulton explained that, as far as the producer of a good or service is concerned, all sales are “consumption.”  The producer of a capital good is indifferent regarding the use to which a purchaser puts the product.  It’s all consumption to the producer, even if it is an investment in future production by the purchaser.
John Maynard Keynes (1883-1946)
Deliberately producing more than can be consumed at current levels of income in order to generate savings — and then artificially creating demand by issuing government debt in order to clear the goods and transfer purchasing power (generate savings) from consumers to producers by inflating the price level is, as far as Moulton was concerned, the height of insanity.  Yet, even though some authorities regard Fisher as the founder of the Monetarist/Chicago school of economics, and John Maynard Keynes of (obviously) the Keynesian school of economics, their respective solutions to the Great Depression were curiously similar: inflate the currency to raise the price level and generate savings.
What necessarily happens under the past savings assumption is that overproduction, from being a temporary problem caused by a lack of purchasing power in an economy in which Say’s Law is functioning, becomes a way of life:
·      To generate savings to finance new capital formation,
·      Producers produce more than can be sold at current levels of demand,
·      Causing goods to pile up unsold,
·      Creating a downturn in the economy,
·      Workers are laid off in response to insufficient demand,
·      The rate of new capital formation declines,
·      Causing demand to drop further,
·      Government issues debt-backed money to stimulate the economy,
·      Artificially raising the price level,
·      Transferring purchasing power from consumers to producers,
·      Which generates savings,
·      Which are invested in new capital formation,
·      Creating new jobs,
·      Which produce more than can be sold at current levels of demand to generate additional savings,
·      Starting the cycle all over again.
Unfortunately, because the effects of the Keynesian “countercyclical approach” are cumulative,
Tyrannosaurus Debt (1776-DATE)
·      The price level tends to go up as a matter of course,
·      Deflation is viewed the same as a decline in the price level whether caused by a restriction in the money supply, decrease in demand, or currency appreciation,
·      Government debt grows exponentially in both inflated and real terms in a self-defeating effort to clear market gluts and create jobs,
·      Consumer credit starts to take up the slack,
·      Further reducing future purchasing power through interest charges and unnecessary spending,
·      Leading to more government debt to bail out bankrupt consumers and producers either directly or by allowing debt repayment with inflated currency.
The only real solution to such a bizarre situation — considered normal under the past savings assumption — is to put consumption and production back together, i.e., restore Say’s Law of Markets.  In an economy in which capital is far more productive than labor, that means only one thing: people must own both labor and capital to be productive, and link productive power to consumptive power once again.
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