One of the most important ideas of 20th century economics was Keynes demonstration that Say’s Law does not hold for whole economies. Say’s law argued that economies will right themselves – tend to equilibrium – at full production. Keynes showed that will economies tend to equilibrium, they don’t tend to equilibrium at what is called a “Pareto Optimal” state. That is the point where there are no “win-win” situations left, in specific terms no one’s utility can be increased without an exactly equal decrease in someone else’s utility. Sometimes the ship of an economy rights itself, by sinking to the bottom.
This conclusion, that economies can stabilize after a shock at a lower level of production was his reason for calling for “priming the pump” stimulus: spending which would encourage people not to defer purchases, or businesses not to defer investment based on fears about the economy. This later leads to General Equilibrium Theory of Kenneth Arrow. The idea is this: the market depends on people making decisions based on obvious and present information, and transmitting the results of that decision by purchasing or not purchasing. This will be reflected in price, and since price information travels, if not immediately, then faster than anything else, the whole of production and consumption will move to a point where everything that people can produce, will be sold, and everything people want to buy can be obtained. However, if people worry about inflation, they will buy earlier than they want, and if they worry about deflation they will buy later. This means the job of government is to make it so that people balance the risks to growth and inflation, and, on net, buy when they want to buy, and save when they want to save.
A deflationary spiral begins with the expectation of future earnings drops, and people both defer buying and businesses defer investing. In Keynesian terms the economy’s liquidity preference rises, and becomes a vicious circle. People want to be liquid, because they see everyone else wanting to be liquid. Money disappears under the mattress of the economy, the velocity of money drops. Keynes observed that “one man’s expenditure is another man’s income.” That means if everyone stops buying, businesses don’t expand capacity, but wait for capacity to fall in price so they can buy it cheaply, and that means fewer jobs, which means less income, which means less buying, which means even more incentive for businesses to wait for cheaper labor and production. Prices never fall enough to get buying going again.
Malthus hypothesized that eventually holders of rent would begin spending. Keynesians countered that holders of rent will not buy production, but will instead buy rents, or buy unproductive labor. That is, they will buy things like paintings and art objects and land, because these things are rents, or buy, and put out of production, competitors. Or they will buy servants and other forms of labor which do not increase the wealth of the society. Thus, sayeth the Keynesians, government, as the ultimate rent holder, is a better “buyer of last resort” than the wealthy holders of rents. Not to put too fine a point on it, the Malthusian solution was tried in the 1930’s – by Nazi Germany, Fascist Italy, and Militarist Japan. The holders of rent in those societies got together and began spending when labor got cheap enough. On weapons.
So how does this work? How can you “just print money?” Well you can’t. But there’s a reason why you can run the printing presses and it works here. Let me explain.
What is money worth? Well it is worth holding money if there is something in the future that you want to buy. Thus, anyone’s willingness to hold currency is going to be predicated on that currency being able to buy something in the future. Now, inflation risk is one people get – your money won’t buy as much in the future, and you can’t rent that money out for enough interest to keep up with that inflation. However, there is another risk, that is the risk of collapse. That risk shows up in two forms, closely related. One is hyper-inflation. A government that is on the verge of collapse runs the presses, people see collapse is coming, and demand higher and higher amounts of money. The government responds by printing even more money. If collapse is not staved off, a spiral begins. It doesn’t matter if the government ran the presses first, or prices shot up first, the result is the same. The other risk is the risk of depressionary collapse, where the very fabric of the economy disintegrates, and there is no future.
The reason both of these are related is that in such circumstances, a government is faced with a “spend or die” decision. For example, during a total war. The government must spend to win the war, or the government is, well totaled. It doesn’t matter what the long term implications are, because lose the war, and there is no long term. Governmental regimes that get into this situation often aren’t very competent to begin with, and printing more money tends to get spent on the very things that got them into trouble in the first place. It doesn’t matter how many checks Chang Kai-Shek wrote, he wasn’t going to win his war, because he was a terrible Commander in Chief. Regimes often face a spend or die situation that is not in the national interest: the country will still be there, but the regime will not be. High inflation becomes hyper-inflation when the tendency to equilibrium is broken.
Governments that fail to spend in such circumstances collapse.
This situation is the converse of the death bet. The death bet is that the actor making the bet will be gone before the negative consequences come to pass. The deflation/high inflation/hyper-inflation bet is that if the government doesn’t make the bet, it’s dead anyway. In finance, this is sometimes called the “eat babies” case. That is, if the bet fails, we will all be eating babies and previous money won’t be worth anything any way.
This is why stimulus, properly applied can work. Because not spending isn’t going to lead to equilibrium, as Krugman pointed out in his “Depression Economics” op-ed, the default isn’t stability that will be disrupted by government changing demand, the default is a downward spiral that will destroy economic arrangements and connections, that will have to be rebuilt at higher cost. Such circumstances are like burning down a house – it is much cheaper and faster to burn down a house, than it is to rebuild it. In normal cases allowing some part of a house to fail and then replacing it is better than replacing everything in the house all the time, but if the house is burning, it is better to put out the fire before it consumes the house.
This is why economists worship equilibrium: in equilibrium situations, one can let unsustainable things continue, because sooner or later they will stop, and the economy will right itself. Covnersely, economists are professional worries, they worry about things that will puncture equilibrium, and the wise ones advise taking steps to prevent disequilibrium, and as importantly, remove even the fear of disequilibrium from people’s minds. Again Krugman neatly points out way: in disequilibrium, one has gone through the looking glass. Sanity is insanity, caution is crazy, timidity is termity. This means, from an economic stand point, that in disequilibrium, all the habits of rational economic actors become destructive to the economy, as opposed to constructive. People can no longer make good decisions, because the very Bayesian backdrop against which they weigh decisions, becomes wrong. By the time enough evidence has piled up that their experience is wrong, it is too late.
For this reason when disequilibrium takes hold, it is necessary to ameliorate, bail out, and provide relief to people who made “bad decisions” – because they weren’t making “bad decisions” in the same sense. Perhaps they were doing things that were unwise in the context of equilibrium, perhaps not, but in disequilibrium many people who made somewhat risky, but acceptable, decisions, are suddenly faced with the loss of everything. Imagine you are playing poker, you win a bit, and gloat. Gloating is perhaps unwise. The person you are playing against pulls out a gun and shoots you in the face. This is a penalty out of proportion to your mistake.
Since it is impossible, or at least very expensive, to go through and decide on a case by case basis whether a person made a risky, but reasonable, decision given expectations of equilibrium, it is better to set rules within which most people were reasonable, and then have relief even for those who might have been outside those boundaries, but who were probably being unreasonable. Within the rules give restructuring, basically wipe the slate clean and set results where they are sustainable in the current environment. This usually means cramming down all of the actors in the decision. Outside, provide relief so that while the people involved might lose all or most of what they have, they are not so wiped out as to be out of the game entirely. People who are out of the game are the source of an economy downshifting to a lower level.
The reason that pump priming works then is because there isn’t some fixed and knowable amount of money in an economy. Instead, much of “money” is that the whole ant hill is working in the first place. It is activity which money controls and directs, and if there is less activity in the future, there is less money. Avoiding the “down shift” – even if it means inflation taxing some of the actors involved – is better because there is more money on the other side.
One problem we have had is that Keynesian economics is counter-cyclical. Governments should be careful and balanced in good times, saving. Governments should spend in bad times. Now this upsets people who are hoping for deflationary collapses, it creates a built in upward spiral on prices. But then, that is better, because it means that fewer people are waiting for prices “to go down” and will work and spend now. However, the win for the people who are prudent in bad times is still quite substantial. By not participating in the bubble, they have not lost. I have clients who have seen their portfolios drop by 70%. And worse, they are in investments that are not going to recover. Had a bad year? I know people who have seen more money vanish in the last year than most Americans will earn in their lifetimes. That’s their personal money. The sensible people come through far better off.
The policies of the Repbulicans, on the other hand, have been pro-cyclical. Run deficits when times are good, throw fuel on the inflation fire, and create bubbles that people can chase. This is because much of the economy has been static for 30 years. It literally is impossible to get ahead in most of the economy except by driving other people out. Thus, people have demanded bubbles, because in these overheated ares of the economy, money is spent freely and fortunes can be made. Pro-cyclical policies, liberals have been pointing out, are unsustainable, because when crisis comes, counter-cyclical action will be needed anyway. This is why hearing from the deficit reduction people now is insanity – where were they when it was time to reduce deficits? Many were calling for “tax cuts” to “return money to the tax payers.” Calling for deficit reduction now means that the cheap dollars borrowed for tax cuts, will have to be paid back in expensive illiquid dollars. Borrowers should borrow expensive and pay back cheap, not the other way around.
Thus the key to pump priming is to divide it into very different kinds of spending. One is pure amelioration: just keep people from going bankrupt and not being ever able to participate in the middle class again. One of the massive failures of the Bush executive was that it allowed the tech bust to happen, and many extremely bright well trained people essentially never went back to earning as much as they had been before. The second is restructuring. This is what incompetent governments get wrong. It is what the last year of the Bush executive has gotten wrong. It is what Obama might well get wrong. Remember, the economy is in disequilibrium, it isn’t enough just to get back to where things were before, because where things were before was what created the mess in the first place.
This is why liberals and progressives right now are calling for broader action, to remove the sources of disequilibrium from society, and balancing the cost of doing this with reasons for people to continue to stay in society. The wealthy just want the instability removed, and they want someone else to pay the cost, and then have things go back to the way they were before. Keynesian stimulus isn’t simply spending, it is spending with an eye to restoring equilibrium, and then recapturing enough to pay back the stimulus. That is, collect taxes on the increased economic activity that preventing a downshift creates, and both paying back that debt, and having a cushion of borrowing power for the next occurance.
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