Wednesday, December 3, 2008

When a Dollar is not a Dollar

We often think a dollar is a dollar. This concept gets us into trouble when we try to understand the economy or economic troubles. If we instead think of two different dollars, financial issues become clear and even Stagflation can be understood. I'll call the first of these two dollars Consumer Dollars to represent money used to pay workers and to purchase consumer goods. It is money that circulates quickly and has a very high velocity. These are the dollars most of us think of when we think of dollars. The second I'll call “Investment Dollars” and represent money used for long term investment purposes. This is money held as stocks, bonds, loans, etc. It has a low velocity. 

Adam Smith, perhaps unwittingly, referred to this when discussing bank notes. He explains the effective difference between “fixed capital” and “circulating capital”. He opposed small bank notes believing that money should only be borrowed in order to procure materials necessary to produce goods. He believed borrowing money to purchase consumption goods was so insane no person or government would ever do it.

Recession and Inflation

Inflation occurs when too much money chases too few goods. The normal response to this is to constrict the money supply by printing fewer dollars or raising interest rates. Recessions occur when too many people are trying to horde too few dollars. The normal response here is to print more money or lower interest rates. When either of these become severe, as in the US in the 70s and in Japan in the 90s, the solutions must become more drastic. They remain the same solution, but become politically more difficult as the remedy becomes more and more drastic. However, these measures only work on the right problem and because there are still many who, for political or ideological reasons, dismiss Keynes, the most effective methods are often vehemently opposed. 

Regardless of the method used to combat recession and inflation, in this context, inflation and recessions are consumer dollar problems.

Booms and Busts

To differentiate Fiscal problems from consumption problems, I will refer to booms and busts as the fiscal equivalents of inflation and recession. A boom is too many investment dollars chasing too few investment opportunities. A bust is too many people trying to horde too many investment dollars. Keep in mind that this behavior can occur regardless of what is happening on the consumption side. Though, this is often clouded with statements like “Wall street is nervous about the new consumer confidence numbers coming out today.”

The solution to a boom is usually pretty simple, but politically almost impossible. Who wants to be the one who ended the party. Unfortunately, not ending the party will result in a horrible hangover. This hangover is much more expensive to fix than stopping the party. I will delve deeper into this in my next post.


So, how does this explain stagflation? In the 70s, we had rising inflation and rising unemployment. Remember that inflation is too many dollars chasing too few goods. The solutions to inflation almost always focus on the too many dollars part. This is what the policy of the 70s did. However, the rising unemployment should have pointed to too few goods as the real culprit, and the fiscal policy of the 70s is also the policy needed to end a boom party. The problem here is there was no party to end. Instead we had a little bit of a headache. When interest rates rose, investment dollars disappeared.

If a factory owner wants to make more money, and demand is high, he can expand production or raise the price. If he raises the price too much another entrepreneur will think “Hmmm, I could make a killing too if I made that.” So he goes to the bank and borrows some money. More likely he would go to an investor, but for reasons I won't go into, the end result is the same and the bank makes things much clearer. Now, if he borrows at 5%, he obviously needs to make more than that to pay his loan back, so if we assume the normal profit rate is 5%, then he needs to sell his goods with a 10% mark up to cover these costs. 

If banks raise the interest rate to 18%, as happened in the 70s, the prospective factory owner would require a 23% markup to cover these costs. The original factory owner can also charge 23% even though his costs are only the 5% normal profit rate. The 18% his competitor must pay becomes, to him, all pure profit. At some point consumers will cease buying the good and those who borrowed the money to fund a factory will go under first. But, unless something significant changes, like a massive recession or a sudden availability of cheap investment dollars, the situation will remain where it is. 

When the Fed turned its policy against consumer dollars instead of in favor of investment dollars, it also hurt the real problem of the economy which was supply and not demand. This has been taken up as the neo-con mantra of economics. However, the trickle down crowd has learned the wrong lesson from this supply crisis. Just as a sudden influx of dollars can un-stick a recession, supply side policies can un-stick a bust. But, an influx of dollars is not an appropriate long term solution to a robust economy any more than trickle down economics is a long term solution. 

This does not completely explain stagflation, how it started, how it ended, and what should have been done. I hope, however, this makes understanding the debate much clearer and helps illuminate the insanity of some “analyses”, especially given our current situation. I wanted to explain how I am thinking about the macro economy before I delved into my understanding of our current mess. 

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