Thursday, October 28, 2010


Out with the dog this morning, thinking about Adam Smith's factors. My economic analysis, like Smith's, relies on a breakdown and examination of costs.

When Smith looked at the world around him, he saw a declining aristocracy, a rising business class, and the immortal laborer.

When I look, I don't see an aristocracy. Land has been pretty well distributed among businesses and working-people. But what I do see is a massive financial sector that did not exist in Smith's time.

The core concept of Arthurian economics is that the cost of interest -- the factor cost of money, to put it in terms Adam Smith might use today -- consumes so much out of wages and profits that our economy just doesn't work any more.

Some of the evidence that the factor cost of money is the problem:
1. Our massive accumulation of debt;
2. The growth of finance as a portion of GDP; and
3. The high portion of corporate profit that arises from finance.

But if the problem is that interest costs consume too much of personal and business income -- that is, if the problem is debt -- then we should be able to find additional evidence of it.

If we have a monstrous debt, then we must have done a lot of borrowing. So there must have been a lot of saving, which was loaned out to generate that debt. Thus if it is true that debt is the problem -- that the factor cost of money is the problem -- then we should expect to see an astounding level of savings.

See it, we do. This graph compares the amount of money in savings to the amount of money in circulation. The numbers come from newer and older sources that don't match perfectly. But you can see the amount of money in savings in recent years is very high by historical standards.

You can also see that saving reached a (much lower) peak just at the start of the Great Depression.

This little history of savings shows a pattern that corresponds to economic conditions. A high level of saving -- twice (that we know of) -- is associated with depression-like conditions.

The graph also confirms our simple prediction that the level of savings must be extraordinarily high to have allowed the level of debt to get so high.

Next we must try to explain our situation. What circumstances allowed the problem to arise? What process contributed to the massive accumulation of debt?

Is it concentration of income that allowed the problem to develop?

The Saez graph is a very good display of the concentration of income. This graph fascinates a lot of people.

Many people look to the concentration of income as a cause of our economic troubles. And indeed, it seems a great concentration of income would permit a great increase in savings.

But a quick comparison of these two graphs does not show much similarity. The concentration of income shown on the Saez graph is high but stable from the early 1920s to the start of World War II, drops sharply during the war, runs flat from 1943 until about 1980, and then takes off for the sky.

The graph of savings relative to money-in-circulation shows an entirely different pattern. The trend line falls from onset of Depression to end of WWII, then starts a relentless increase, interrupted only from the early 1980s to the late 1990s.

I don't see a similarity between the two graphs that would suggest a cause-and-effect relation between the concentration of income and the growth of savings. Therefore I cannot say that the concentration of income is what led to the great accumulation of savings and debt.

I can say, however, that even in conditions of absolute income equality it would be possible to accumulate too much saving and too much debt.

A Thought Experiment

Imagine a world where everybody gets paid exactly the same as everybody else, no matter what job they do or how good they are at it. Assume for a moment that such a world could exist, and that incomes are all still equal the next day, the next week, and the next year.

I like this little society of absolute equals, this Neverland, because it is easy to picture: everybody in it is exactly like me. But even in this hypothetical world it would still be possible for debt to accumulate to an excessive degree. All it would take is for people to think the same thing that we think: that credit use is a good thing.

Oh, credit use is a good thing, but that thought is unfinished. Credit use is a good thing when we have too little debt. Credit use is a bad thing when we have too much debt. And, yes, credit-use is good for growth, but too much credit-use is bad for growth. I don't like reducing things to "good" and "bad," but there it is.

So now, suppose we all get thinking that credit use is a good thing, and we all start using more credit. Well, pretty soon we start running out of money to borrow. So policymakers come up with policies to get us to save more. Problem solved.

But when we save more, we spend less. Solving one problem creates another. Demand grows less, because we're spending less. The economy slows.

But we know that credit-use is good for growth. Our economists and policymakers exhort us to go out and buy stuff to stimulate the economy, and put it on the credit card. And of course we want to do that. And we do.

Things pick up some, and policymakers see that their decisions are good. So to get the economy to grow more, they do things that encourage even more credit-use. And of course then they have to do things to encourage increased saving. And on the graph of saving relative to M1 money, the trend-line goes up.

After a generation or so we seem to notice banks becoming a more important part of our daily routine. And still we find our economy growing more slowly than we want.

And after a while our debt is so big, and our interest payments so burdensome, that they eat into our spending-money, and we have to cut back on our consumption. And interest costs in our businesses are eating into profits, so we have to raise our prices.

And after a while we had this mild but relentless inflation, and all that debt, and our living standards are not what they should be, and the world is going to hell in a handbasket, and the economy just doesn't work any more.

Thus we end up with excessive debt. But at least we're all in the same boat, right? I mean, we are in the middle of a thought experiment where there is absolute income equality.

The moral of the story: Even in a world of absolute equality, we could end up in the same mess we are in today: a mess of excessive debt and excessive savings and relentless inflation and perpetual sluggish growth. It does not depend on the concentration of income. It depends on the reliance on credit.

And the problem, in case you missed it, is that we use dogmatic, open-ended rules of thumb in our economic thinking, rules of thumb like printing money causes inflation and this one: "Credit use is good for growth."

Open-ended rules are rules we apply without letup. The inflation rule tells us that if there is inflation, they must be printing too much money. But the rule doesn't ever have us check to see if there is even any money left.

And the credit rule tells us that if we want the economy to grow, we need to use more credit. This rule doesn't ever have us stop to see if we've used too much credit already, if we've accumulated too much debt, if we've passed a Laffer Limit, if we've crossed the line. The rule just tells us to use more credit.

In the Arthurian view, these two rules of thumb together created the problems in our economy. We always restrict the quantity of money, and we always use more credit.

After you do those things for a good long time, the economy doesn't work any more.


greg said...

I'll bet if you do the math you'll find that the American owned portion of the national debt equals the savings levels.

Check this video out. This woman does a very nice presentation, she's a better speaker than Mosler.
She's kinda HOT too!!

Look only at video one. Video 2 is a Q&A session.

Greg said...


I did my own thought experiment today. I took your advice and wrote more. Let me know what you think.

I'm still pondering your thought experiment. Especially where you said that income inequality doesnt seem to matter. Yes you've shown that a society that starts out with equal income, has the same views on credit and overextends them selves the same would also crash. I'm not sure that anyone is making the argument that inequality is a sufficient and necessary condition for what we've experienced, but when you have one segment massively indebted to the other (with no income growth to sustain it) there will be a day of reckoning. Yes debt is the problem but there are those (with high incomes and high net worth) who have very little relatively speaking and others with a very high ratio. All it takes is for about 10 percent to have an unsutainable debt load and it can ALL come crashing down.

The Arthurian said...

Good post, Greg. Glad to see you took my advice!! And so you know, I'm starting to get a better idea of what MMT is all about.

RE my thought experiment... I don't want to say income inequality doesn't matter. Certainly income inequality can hasten or deepen the problems caused by excessive debt. But in particular:

...when you have one segment massively indebted to the other (with no income growth to sustain it) there will be a day of reckoning.

In a "perfectly" equal society, we could have one segment, massively indebted to itself!

It is not impossible to think that the worse economic conditions get, the more people will desire to set aside money for their economic security.

It is not impossible to think that savers want to keep their savings in savings -- and also to keep the earned interest in savings, too... The more so, perhaps, in times of economic troubles.

So even in a society of equals, human nature and mathematical forces could combine to cause debt to increase to an unsustainable level. And so much more plausible is the possibility, in a society of advanced inequality of income and wealth!

But the problem is not inequality; the problem is excessive debt.

Yet even today, everywhere I look I see policymakers doing things to increase the availability and use of credit. It still occurs to almost no one, that excessive reliance on credit is the cause of our problem.

Greg said...

One thing I'm not sure your accounting for is the currency issuer. They still have the power to "fund" the savings desires of the private sector and keep aggregate demand high enough for employment not to fall.

In that video I asked you to watch with Stephanie Kelton, there was a second video with a Q&A session. Very poor audio for parts of it but one place you can hear Mosler very clearly and he is talking about inflation (not hyperinflation) and he says something interesting. That inflation is never a REAL problem. It is simply a situation that humans get uncomfortable with and we must remember that but there is never real economic hardship DUE TO inflation. People are getting richer and paying higher prices but they can meet all their financial obligations out of their incomes usually. I dont care if bread is 6$ loaf if I only have to work 5 minutes to earn that 6$. The real question is how much work am I having to do to pay my cost of living, and in most inflationary situations through history, that is not usually a problem according to Mosler.

I think we get waaaay to inflation scared and therefore always run deflation bias which kills us in times of large debt.

The Arthurian said...

Following up:

... you said that income inequality doesnt seem to matter... I'm not sure that anyone is making the argument that inequality is a sufficient and necessary condition for what we've experienced...

I had in mind my son Jerry who is so fond of Emmanuel Saez's graphs. But here, check this out. A comment from Jeff, on a recent Krugman post. And it is recommended by 42 Readers, so far.

I think a lot of people see inequality as the problem.

I see debt as the problem. And I see the growth of inequality over the last 30 years as an insane attempt to solve the problem.

We could undo all of the growth-of-inequality of the past 30 years, and it would not solve the problem... Because the problem arose in the 1970s, and then since the 1980s policies promoting inequality were applied as a solution.

The problem arose in the 1970s. Inequality-growth arose in the 1980s.