We said in the previous posting in this series that the belief that the government can do anything and everything better than the private sector, especially control the financial system, are two of the most damaging assumptions ever made, economically and politically speaking. We could argue whether they are the same assumption, but why waste time on a useless quibble? The fact is that both of these assumptions are themselves rooted in the belief that the only way to finance new capital formation is to cut consumption and accumulate money savings. Given that, and the demand that "the government should do something" leads to the paradox of trying to fix a bad system by making it worse. Nowhere is this more evident than in government manipulation of the financial system in an effort to deny economic reality.
The Formation of Capital upsets one of the most fundamental assumptions in modern economics and finance: that new capital formation is impossible without first cutting consumption, saving, then investing. This assumption leads to treating commercial bank credit as if it were a commodity in limited supply. (Harold G. Moulton, Financial Organization and the Economic System. New York: McGraw-Hill Book Company, Inc., 1938, 402.) Modern economists thereby assert that the "supply of loanable funds" determines the "production possibilities curve," that is, the rate at which economic growth can be sustained.
Moulton believed that treating bank credit as a commodity was largely responsible for the slow pace of recovery from the Great Depression. Consequently (as we have seen), Brookings set out to analyze the financial causes of the Depression and formulate guidelines to develop a recovery program. Brookings published its findings in America's Capacity to Produce (1934), America's Capacity to Consume (1934), The Formation of Capital (1935), and Income and Economic Progress (1935). These volumes examined the structures and institutions of the American economy in the wake of the Crash of 1929, and presented the results of Brookings' "investigation of the distribution of wealth and income in relation to economic progress." (Edwin G. Nourse, "Director's Preface," Dr. Harold G. Moulton's Income and Economic Progress. Washington, DC: The Brookings Institution, 1935, vii.)
Although these books were written in response to a specific set of historical circumstances, the reader will see distinct parallels in the 21st Century with today's economic downturn and global financial crisis. Although Moulton presented basic principle of economic recovery in broad terms and without specifics ("It would need to be highly detailed to meet the peculiar situations of varying industries, and the time is not yet ripe for the presentation of anything more than general principles," ibid., 164.), he clearly stated that, "If we are to achieve the goal of satisfactory standards of living for everyone, the first requirement is to increase progressively the total amount of the income to be divided." (Ibid., 83.) In other words, the solution to economic downturn is not redistribution, but increased production in order to have income to distribute. As Moulton explained,
"The distribution of income from year to year is of primary significance not for its momentary effects upon the well-being of the masses, but for its possible cumulative effects in promoting a fuller utilization of our productive facilities and a consequent progressive increase in the aggregate income to be available for distribution. We are not interested in maintaining a static situation in which the total income, even if equally distributed, would be altogether inadequate; we are interested rather in producing a dynamic situation in which increasing quantities of newly created goods and services would become available for everyone." (Ibid.)
This is consistent with Say's Law of Markets, which, simply stated, is that production equals income, and thus supply generates its own demand, and demand its own supply. As Jean-Baptiste Say explained in response to some criticisms of his theories by the Reverend Thomas Malthus, "if certain goods remain unsold, it is because other goods are not produced; and that it is production alone which opens markets to produce." (Jean-Baptiste Say, Letters to Mr. Malthus on Several Subjects of Political Economy and on the Cause of the Stagnation of Commerce. London: Sherwood, Neely & Jones, 1821, 3.)
The problem, therefore, in any economic recovery, is not over- (or under-) production or consumption, or manipulating the price level, the velocity of money, or, worst of all, the volume of money. The problem is threefold: 1) how to increase production, 2) how to distribute the income from production according to relative inputs of labor and capital, and 3) how to distribute that income to people who will use the increased income for consumption, not reinvestment.