Modern Monetary Theory - Fraud 6 - Investment and savings

This is the sixth part of a critique of some of the thoughts expressed by Warren Mosler in his booklet "Seven Deadly Innocent Frauds of Economic Policy"

===========================

Deadly Innocent Fraud #6: We need savings to provide the funds for investment. Fact: Investment adds to savings.

This assertion can be shown incorrect through considering the case of no savings, which is the same as when consumption is equal to production. If we are consuming everything that we produce, what could possibly remain available to invest? The confusion here stems from equating money to wealth, or by equating financial capital with the capital represented by the combination of productive capacity and by consumption products that have not been fully exhausted or worn out.

To elaborate, for the economy of Robinson Crusoe (an occasionally useful gedankenexperiment), his daily consumption of nuts and berries is what he manages to produce/collect each day. His other consumption is time at leisure, which besides accounting for our daily food and shelter is perhaps the most valuable good that many of us desire. If RC wants to expand his consumption to fish he must make savings from his other consumption for the time and resources it will take to collect materials, weave a net, catch the fish, prepare fire and cook the meat. For all the time RC is making those investments he must live off of nuts and berries he collected and saved from the past.

For the individual living in society, if she spends every penny of earnings there is nothing left over to improve her situation. The case is directly analogous to larger groups of people; if they consume everything they produce there is no savings, and there is nothing left over to invest. It doesn't matter how many currency units are in circulation, because the investment in increasing production requires there to be available actual factors of production sufficient to generate increased output - the currency units are only the accounting mechanism that helps everyone trade for what they want and need to obtain those ends.

RC's investment of time and materials for fishing has other effects, principally that once the investment is complete his production increases with the addition of fish to his diet, and he has more time to spend in leisure or in other enterprises. RC has more food to eat and it takes less total time to collect it - his cost of living has gone down as a result of his investment. Additionally, RC may now also take time to keep his nets in good repair, activity that constitutes capital replenishment; he can choose whether to let the original net wear out and build a new one at that time, but he cannot choose to do nothing unless he wants to fall back to his nuts and berry collection routine. In an economy with hundreds of millions of participants the difference is in the intricate network of interactions that make up the structure of production, but the fundamental causes and effects are the same.

Mosler summarizes the paradox of thrift on page 63 with

If anyone attempts to save by spending less than his income, at least one other person must make up for that by spending more than his own income, or else the output of the economy won’t get sold.

The short answer is that this assessment fails to account for the producers lowering prices to the market-clearing level, which also has the effect of increasing real income for purchasers of goods and services. And this is not just after the fact lowering of prices to dispose of otherwise unsold inventory. When people invest in new capacity, the entire supply and demand relation shows that more people will purchase a good at lower prices, so increased production must be planned with the expectation of lower prices, or the entreprenuer will experience a loss in her venture because insufficient sales will ensue at higher prices.

What happens if such increase in savings is taking place through the economy? The effects in the structure of production can be complicated, but some features tend to come out. Consumer spending is necessarily on consumer goods, so prices for those goods would tend to decrease, and suppliers of those consumer goods will see profit margins fall and the marginal suppliers may go out of business. The unseen effects take place on the other end of the production network, where the new savings is available for investment.

An increase of savings means that people have lowered time preference; they are willing to reduce their expectations for return on savings, decreasing interest rates. Lower interest rates mean that some investments become profitable that were not profitable at the higher interest rate. The farther out the investment return, the more of an effect this reduction has. The farther out investments are also the ones that are farthest from resulting in consumer goods. All this tends to shift the structure of production into more long range plans and less supplying for direct consumption, which is exactly what the consumers spending preferences are saying should happen. The effect of this is to increase future production, which aligns with the consumer choices to save their current resources to allow for future consumption. Increasing production lowers prices. Lowered prices means increasing standards of living - real income increases, measured by the ability to obtain the same or greater amount of goods and services for the same or less expense. This is the solution to the paradox of thrift - thrift results in increased production which reduces costs for everyone.

That is the laissez-faire condition. The problem with the Fed's artificial reductions in the interests rates is that it does not reflect a true shift in consumer sentiment to be more future-oriented with less intense time preferences, but rather encourages borrowing on all fronts. Low interest rates encourage spending on the higher order long term production processes, and at the same time encourages additional production in the lower order consumer goods. And worse, in as much as that borrowing is done to finance investment of capital goods that are less applicable to higher valued consumer preferences, they are more difficult to convert to alternative consumer wants when the investment is shown to be a loss and must be liquidated. Such difficulty makes the inevitable readjustment that much more difficult to achieve, worsening the effect of the bust. If the local specialty pizza maker decides on the basis of low interest rates that she can invest in a new pizza oven, and the pizza-oven maker decides on similar basis to expand pizza-oven-making capacity, it does neither of them any good when the consumer disposable income is shown to be inadequate to buy sufficient pizzas to justify the investment (when the consumer borrowing comes due).

What leads to the recession after the boom is that the level of production in excess of consumption - what is available to invest - has not actually risen to the point required to sustain that production in combination with the coincident increase in consumption. To be more clear, the production I'm describing here is that of the producer goods and services that go in to trying to raise production according to the investment. These have actual physical and temporal limits, so it does not matter how many currency units are in account.

When the system allows expansion of credit in excess of actual savings then the economy starts down a path of unsustainable investment. We can add as many zeros to account as desired and it won't change the fundamental physical limits of what can be produced in the then-current structure of production. As the actual limits of producer goods and services begins to be recognized, prices start to rise precipitously as the disconnect sets in, followed by the collapse when people realize the conditions are unsustainable. For any recovery to follow, the losses must be wiped out in a more or less painful process of adjustment. To keep the boom/bust cycle from happening again we must first refrain from the initiating conditions of credit expansion.

The example of car makers borrowing to make hybrid cars slips over the real point when Mosler says "there would not yet be anything to buy" (p.64); the only way there is anything to buy when developing new capital equipment is if there has been savings from prior production that can be consumed during the interim.

As for the statement that "This is why the seemingly-enormous deficits turn out not to be as inflationary as they might otherwise be" (p.65), what Mosler seems to be missing is how increasing production reduces real unit costs. With stable money such as during the latter half of the 19th century in the United States, increasing production drove reductions in real costs for goods and services and led to increased living standards even while prices were dropping. These days, our fiat currency is progressively debased as a point of "stable prices" policy, and the relatively low inflation should be compared against what would otherwise be progressively decreasing prices. In other words, the inflation is understated to that extent. By the way, this is also one reason why changes in quantities such as gross national product do not necessarily relate to changes in the underlying per capita living standard.

The complicity of financial institutions in this situation is not difficult to understand - as generally the first recipients, they are the ones who most directly benefit from the currency and interest manipulations.

A side point about inflation...

It can be argued that any unused industrial capacity could be put to work using printed dollars, with the result being non-inflationary. I think this is incorrect due to the fact that the entire set of resources necessary to support that production is already committed to something else, which currently offered prices are insufficient to overcome, even if that use is simply to reserve the factor for some future use. For example, the owner of a mine may not operate it to full capacity because the going prices for the product, and more importantly the projected future prices, are insufficient to overcome her predictions about what the corresponding costs of production are likely to be. This is part of how entreprenuers deal with the uncertain future, and also illustrates conservation principles in how people are consider the future value of the resources under their control.

If under these conditions the government comes in with newly printed dollars and tries to buy up those resources to increase production in some way, it must bid higher prices to pull the resources out of reserve, which starts out the inflationary effects. Another consideration is that the completion of every productive activity requires the coordination of a large number of factors, some of which are almost certainly fully occupied in some other activity; in these cases the government-directed production introduces a new competitive force for the use of those resources, which also has inflationary effects.

A third deleterious effect relates back to the overall problem of credit expansion, which is that investment in new resources can only come from resources that have previously been saved from consumption. At the level of the entire economy it is difficult to detect uniquely as a consequence of one or another specific spending project, but in each case the effect is to pay people for goods and services needed to complete the project using goods and services that do not yet exist.

Another side point, about the fractional reserve banking system ...

Once upon a time, when banks were originally created, they served as a warehouse for the storage of gold and other precious metals, used by people who found it inconvenient to store the money on their own property. Before long, warehouse receipts were used to represent the fact that a given warehouse held an amount of gold money in trust, and those receipts began to be traded as money substitutes. So far, so good - one warehouse receipt for each unit of gold kept in reserve.

At some point an unscrupulous warehouse owner thought she might take advantage of the fact that warehouse receipts became more convenient for trade than the gold money itself, so people might not very often make a claim on the actual gold in storage. The warehouse owner might have then issued more receipts than were actually backed by gold in the vault, which was a fraud. If you put a piece of furniture in a personal storage unit because you don't expect to need it for a few years, it is a fraud for the storehouse owner to rent out the use of that furniture in the mean time, and so it was for these money substitutes.

Even so, this was a controlled situation, because people started clearinghouses to exchange the gold warehouse receipts that came from various sources. Those people were in the business to make sure that issuers of warehouse receipts would exchange such receipts for the actual gold, and kept the unscrupulous dealers in check.

Then the government entered the picture, with the intention of lavish spending, mostly on war, made alliance with powerful bankers to legalize this fraud, to pay for the war and other expenditures of political whims. At the same time, the bankers were allowed to make loans using these fraudulent notes, which of course increased their profits. The result was fractional reserve banking, whereby any bank need keep on reserve only a fraction of the money actually held as demand deposits by thier customers, which has been a major contributor to credit expansion and related financial booms. Today in the United States, the fractional reserve requirement is 10%, which means that the banks can pyramid the money supply by ten fold for each dollar in reserve.

For more on this, Rothbard is a good source for criticisms of the fractional reserve system.

-------------------------

For more of this discussion, see the following posts concerning the other frauds

Introduction

1 - Government Spending

6 - Investment and savings

7 - Future effects

Wrap-up