Sunday, March 15, 2015

This is cost


Geerussell links to Bill Mitchell from 2012. This part catches my eye:
The neo-classical production function analysis, which is standard in most textbooks, assumes that in the short-run, will all other productive inputs (capital, land etc) fixed, output will increase at a decreasing rate as more hours of employment are used by firms.

This is the so-called Law of Diminishing Marginal Productivity and allows economists of this persuasion to postulate an increasing marginal cost relationship with respect to output (costs increase at an increasing rate as more output is produced).

From that excerpt I take this:

The Law of Diminishing Marginal Productivity lets you say costs increase at an increasing rate as more output is produced.

To be sure, Mitchell says The Law of Diminishing Marginal Productivity "is a theoretical construct – an unproven assertion. No conclusive empirical evidence has ever been assembled to substantiate the “the Law” as a reasonable generalization of production relationships in modern monetary economies."

Okay, that's fine. I'm not arguing for or against the law of diminishing marginal productivity. I'm just trying to look at it for a moment.

What I see is "cost". The word "cost". If the Law of Diminishing Marginal Productivity is true, then it operates by affecting cost. This is what makes the concept powerful.

Here is what I think:
The economy is composed entirely of transactions. In every transaction, cost is a consideration; often it is the most important consideration...

Because the economy consists of transactions, because transactions always occur at the intersection of cost and price, and because cost is always the limiting factor -- we are always willing to accept more in payment, but we are not always willing to pay more -- cost is the most significant of all of economic forces.

So, the Law of Diminishing Marginal Productivity gets its power from the cost it imposes on the economy. No matter the cost may be imaginary. Cost -- or the vision of cost -- gives it power. You can't get around cost.

I bring this up because my argument is also a cost argument:

Imagine a world where there is $3.50 of debt for every dollar of spending-money. Now, gradually, over 60 years, the level of debt increases to $35.00 for every dollar of spending-money.

Graph #1: Dollars of Total (Public and Private) Debt, for Each Dollar of Spending Money

If the interest rate is fixed at one percent, then at the start debt imposes a cost of 3½ cents on every dollar of spending-money. By the end, debt imposes a cost of 35 cents on every dollar.

If the interest rate is three percent, the interest cost is 10 cents per dollar at the start. By the end, the entire dollar is absorbed into interest. This is the cost of finance.

This is cost.

You are supposed to realize without my saying it, that my cost argument is the better argument.

6 comments:

Auburn Parks said...

Obviously, higher interest cost is a burden that comes along with higher debt. BUt I dont see the relevance of comparing this to M1. M1 is by no means the definitive accounting of "money" in the economy. So what is the point?

If I currently have debt outstanding of $100K and only $10K in a M1 account, then this ratio is 10:1, but if I also have $50K in TSY saving accounts (securities) at the Fed bank, then my debt to "money" ratio would be 2.5:1 but this is ignored with your use of the M1 figures. The same thing can be said if I had $50K in CD savings accounts at Chase or Bank of America.

In other words, debt to income or "money" is an important ratio and concept, however, using M1 to demonstrate the ratio is nearly meaningless at best and misleading at worst.

The Arthurian said...

"using M1 to demonstrate the ratio is nearly meaningless at best and misleading at worst."

Well, you certainly don't know that.

The relevance of comparing debt to M1 money is that M1 money is the money people ordinarily spend. If you have $10K it probably won't be in an M1 account. It will probably be in a time or savings account, collecting more interest than it can ever get as M1.

Maybe you'll leave $1K as M1 for contingencies.

M1 is the money we ordinarily spend. That means M1 is the money that's available for paying off debt. Anyway, if you want to use your entire $10K for that purpose, you'll have to move it to an M1 account first.

If you have 10K as M1 and 50K as Tizzies, it seems to me you are pretty unlikely ever to need to convert your Tizzies to money to pay down debt. Money that has moved out of the spending stream and into savings is unlikely to return to the spending stream. This is why I use M1 where other people use broader measures. But it is quite unrealistic to think that savings are as likely to be spent as spending-money.

"In other words, debt to income or 'money' is an important ratio and concept..."

You put "money" in quotes there, so I think you are using it as I might if I said "I go to work to make money". The word "money" here means income. Assuming this is right, let me shorten what you said:

"In other words, debt to income is an important ratio and concept..."

I prefer not to use income in that ratio because anyone can boost income at any time by taking a loan and spending it. However, this method does not only increase income. It also increases debt.

Lunch time!

Greg said...

"I prefer not to use income in that ratio because anyone can boost income at any time by taking a loan and spending it. However, this method does not only increase income. It also increases debt."

Im not so sure about that. Not ANYONE can just go get a loan to increase their income. Many have already maxed out the amount of debt their income will service, so I think debt to income is the proper ratio to look at.

This is why monetary policy has limited effectiveness in recessions, as incomes are falling more and more people have reached the limit of debt they can service with income and are resisting using savings to pay down debt (if they have any savings). Monetary policy is ONLY effective through the lending channel. If loans don't increase monetary policy cant do anything. One cant make someone take a loan. They can make a loan cheaper, or look cheaper, but you cant force someone to borrow.

The Arthurian said...

Greg: "Im not so sure about that. Not ANYONE can just go get a loan to increase their income. Many have already maxed out the amount of debt their income will service, so I think debt to income is the proper ratio to look at."

So Greg, you are looking at the economy as it is at the moment? You have to look at the economy as it goes through all of the phases it goes through.

You seem to be saying that my whole argument falls apart because I used the word "anyone".

Oh, and I certainly did not mean to suggest that people can increase their own income by borrowing. No no no! By borrowing (and spending) we increase the income of others!

jim said...

"Oh, and I certainly did not mean to suggest that people can increase their own income by borrowing. No no no! By borrowing (and spending) we increase the income of others!"

Borrowing does increase income of others, but that increased income often is not counted as part of GDP. For instance, if you borrow to buy an existing home, the income to the seller of that home is not included in GDP.

So it seems to me that if you want to understand to what extent borrowing is connected to changes in GDP, you need to disaggregate the uses of money received by borrowing into spending that contributes to GDP and spending that does not.

Greg said...

"So Greg, you are looking at the economy as it is at the moment? You have to look at the economy as it goes through all of the phases it goes through.

You seem to be saying that my whole argument falls apart because I used the word "anyone""

No Im just agreeing with Auburn that your use of M1 as THE metric of money is limited and tends to bias your ratio bigger. I think debt to income ratio is the most important metric because most people DO service their debts from their income flows, but I don't think there is any reason not to use M2 when calculating your ratio. M1 is not any better indicator of income than M2 is. I use my income flows to build my savings as well. Price appreciation affects savings in things like stocks or commodities but its still extra income that is used to acquire those saved things.

If every dollar of my current income is going to service old debts then I cant raise anyone else's incomes til I pay down some debts.... and often I will do this by purging my savings.
Paying debts is servicing previous consumption, growing GDP means increasing present consumption.

If you want to use debt to dollar as a metric use ALL dollars not just M1. Yes the number will be smaller but I don't think the bigger number is any more meaningful.