naked capitalism

DoctoRx raises a wide swath of excellent questions regarding the correct approach to financial crises, the economic contractions they can induce, and the best way forward. I will focus on some of the key points he introduced with regard to the financial balance approach, since he cites some summary comments of mine on the basic orientation and conclusions of the model, while perhaps Marshall and Ed will chime in later during the week to address the questions he poses for some of their prior posts on the issue of policy orientation.

Early on, DoctoRx asks, is debt the core of the problem? Debt related issues certainly seem to be a recurring contributor to some of the sharpest economic dislocations we witness across time, across regions, and even across economic systems. A lifetime ago, a highly esteemed US economist and entrepreneur named Irving Fisher had to lose his fortune and his house in order to question the general equilibrium approach which still to this day guides mainstream economics. In act born no doubt out of humility and direct experience, he subsequently stepped beyond his general equilibrium conclusions and tried to make sense of the conditions that spawned the Great Depression.

Fisher’s conclusions included the insight that the degree of financial leverage in the private sector matters greatly to the ability of the economy to right itself after any disturbance. His insights are fortunately summarized in a 1933 article, published in the first issue of the journal Econometrica. If you take the time to read it – it is written in plain English, not technical jargon or abstract calculus – and if you consider the parallels with recent events that can be found in his cursory model of what he called a debt deflation dynamic, I suspect you will find yourself agreeing that debt is indeed the core of the problem. If Fisher’s contribution fails to be persuasive, then I would recommend taking a look at the chapter in Hy Minsky’s recently reissued book, John Maynard Keynes that is entitled “Financial Institutions, Financial Instability, and the Pace of Investment”. Either one should do the trick.

To grossly oversimplify, the problem with debt is it sets up fairly fixed future cash flow commitments, of which there is no automatic mechanism guaranteeing that future cash flow generation by the economy will be sufficient to meet. If private sector leverage gets large enough – and Minsky argues there are inherent dynamics that drive the economy in this direction – then the failure to meet contractual commitments can lead to forced asset sales, falling asset prices, and a restricted propensity to invest out of profit income flows and to spend out of wage and salary income flows, all of which can fuel a vicious, self-reinforcing cycle very much like we witnessed from September 2008 to March 2009 before massive policy intervention broke the maelstrom.

DoctoRx suggest that as long as the entire private sector is not bankrupt, and only some units in the economy are debt distressed, then bankruptcy or debt renegotiation for those units is the best response. This sounds eminently sensible, and it is also a central tenet of the Austrian School approach to financial instability. However, many of you may recall there were central bank officials, including the Chairman, as well as many Wall Street executives and analysts, who repeatedly asserted the subprime mortgage crisis was, to put it in their words, “contained”. This assessment was clearly incorrect. There apparently was enough leverage within the financial system itself, within the household sector, and within the nonfinancial business sector, that the “contained” subprime crisis spilled over into the deepest and longest economic contraction since the Great Depression. So perhaps there is some threshold level of indebtedness beneath which bankruptcy and debt renegotiation can be a successful approach, but clearly, we crossed that line, and given the number of episodes of financial instability I have witnessed over the past quarter century of my career, I would have to add we seem to have an uncanny ability to keep crossing that line.

DoctoRx next considers a contradiction in using policy responses to debt deflation dynamics that require higher government debt. He suggests we best think of the government balance sheet as consolidated with the domestic private sector balance sheet, since Treasury debt is an obligation that ultimately must be paid by taxpayers. This of course is a variant of the Ricardian equivalence argument, whereby fiscal stimulus is deemed to be ineffective at inducing economic growth since the households receiving higher income from deficit spending simply save the entire proceeds in expectation of future tax liabilities of equal magnitude. DoctoRx is probing along similar lines when he observes, “after all, the private sector has to debit its bank account to send the funds to the government in order to buy the debt. All that is really happening is that the private sector had cash, and now the government has the cash with some repayment terms.” Fiscal deficits are, in other words, just an asset swap.

This takes us directly into some of the most controversial and powerful observations of what can be called a functional finance view of government deficit spending. We can start from the realization that the household and nonbank business segments of the private sector cannot create cash – that is called counterfeiting. They have essentially 3 ways they can net accumulate cash: 1) by selling assets to or borrowing from banks (bank loans and bank security purchases create deposits); or 2) by the federal government spending more than it receives in tax revenues, such that the private sector receives more cash inflows from government spending than it pays in cash outflows in federal taxes; or 3) by the central bank (the Federal Reserve) expanding its balance sheet by purchasing assets from nonbank firms and households.

In general, the federal government can and does create the cash that the private sector receives when the federal government deficit spends or when the central bank purchases assets from the private sector. For example, when a household receives an unemployment benefit from the federal government and deposits it in its bank account, the Federal Reserve credits that bank account. Neither the Treasury nor the Fed needs to collect the cash from the private sector before hand. Indeed, the private sector can only net accumulate cash if it sells labor time, products, or existing assets to the federal government or the central bank first. What is missing from most depictions is a clear idea of how money is created and destroyed in the economy that we actually inhabit. Until it is understood how the nonbank business and household sector as a whole can get their hands on money, since they cannot create money without risking a jail term for counterfeiting, then much about fiscal policy, monetary policy, and private saving remains mystified or misunderstood.

Next, DoctoRx proposes several examples of how the private sector can accumulate equity, net worth, or real savings that “do not become anyone’s liability”. He cites as possible demonstrations the following: “consider obtaining enough milk to meet the needs of many children from a cow that eats free grass, building a cabin from logs cut from nearby trees, or building a bridge to create an important crossing point of a river”. Here, we are dealing with a primitive economy that appears to have limited private property rights and no money. Most would agree that does not resemble the economy we inhabit.
Typically, modern production requires large scale capital equipment, and the acquisition of that equipment must be financed. Even the proverbial two guys in the garage creating the next Apple have credit cards they are maxing out. Moving to the macro level, assuming for simplicity no foreign trade and no government sector, it is possible to demonstrate the conditions required for business capital investment to be internally financed, which is probably closer to the point he is trying to make. It is quite simple: the household saving rate must be zero, which means we all die of starvation upon retirement.

By way of illustration:

Total income = profits + wages = P + W

Total spending = investment + consumption = I + C

Total income = Total spending

P + W = I + C

P = I + (C – W)

Assuming no payments to households out of profit income, W – C = household saving

P = I only if W – C = 0

But even then, with investment equal to profit, there is a timing problem, since profits only show up after the sales of produced goods and services. In a monetary production economy – that is, one not characterized by barter exchange of products for products, where production takes place only in the expectation of or search for money profits – the business sector has to gets its hands on cash to set production in motion (since sales revenue follows the act of and the costs of production with a lag), and they usually do this by borrowing from a bank, which creates money and debt in the process (loans create deposits, deposits are acceptable means of settlement, or money). So credit and money are deeply intertwined with real production and the accumulation of tangible plant and equipment, at least in the economy we inhabit, rather than the hypothetical Hobbit shire DoctoRx offers up.

Finally, DoctoRx suggests “the private sector can be profitable while the public sector is simultaneously profitable. Or, both can be unprofitable…If in fact the economy is net unprofitable, then kicking the can over to our doppelganger, the Federal Government that the States created, will not change the underlying economics.”

The financial balance approach may shed some light on these three configurations. If in the aggregate, total income must equal total expenditures, and total investment must equal total saving, and we define the financial balance of any sector of the economy as sector income minus sector expenditures, or sector saving minus sector investment (they are algebraically equivalent), then the following must hold true:

Household FB + Business FB + Government FB + Foreign FB = 0

In other words, the sum of the sector financial balance must be zero. Note the foreign financial balance is the negative of the current account or trade balance. When foreigners net save, we are running a trade deficit, spending more on imports than we earn on exports. So yes, the business sector and the government sector can run a financial surplus (what DoctoRx calls being “profitable”) if the household sector is willing to deficit spend, and/or the trade balance is in surplus. Or both the business sector and the government sector can run a financial deficit, if the household sector is net saving and/or the trade balance is in deficit (and hence the foreign sector is net saving). Finally, the business sector will run a net saving position (or will be net profitable, in DoctoRx’s terms) when the government deficit spends as long as household net saving or the trade deficit do not increase as much as the government deficit.

There are obviously many permutations that we could investigate on end. The point is to think coherently and consistently about these sector flow imbalances, to try to understand what combinations are indeed compatible and possible, and then try to find ways to support sustainable growth trajectories. In the period following a financial crisis, it is not unusual for the private sector to seek a net saving position. For the private sector to achieve its desired financial surplus, the fiscal balance must fall and/or the trade balance increase in an offsetting fashion, or income will fall, and debt deflation dynamics will take hold. Without the financial balance framework, it is difficult to see such things very clearly, but even Paul Krugman is starting to get it.

So keep going DoctoRx – you are asking some very important questions. Finance matters – especially debt and leverage in general – to real economic outcomes. Money and finance are not neutral with respect to real economic outcomes, nor is money simply a veil for real exchange, as is taught in mainstream economics and as is held as holy truth by contemporary central bankers. Read a little Fisher or a little Minsky, and then reflect on recent events. Did we destroy some productive resources, lose some technical knowledge, or otherwise experience an exogenous productivity shock to drop into the deepest recession of the post WWII period, or was the drop in real economic activity in no small part a result of a highly leveraged private financial and nonfinancial sector encountering some very drastic financial conditions as fraudulent loans and fraudulent debt ratings were exposed? Does the government need the private sector’s money to “fund” its expenditures when a) the nonbank private sector cannot create money, and b) the government creates the money the private sector accumulates to pay taxes and buy bonds? Under what conditions can the business sector as a whole accumulate tangible capital without issuing financial liabilities, and are those conditions we observe in the real world around us?

Finally, how can we think coherently and consistently about sector financial balances, and what does an analysis of these sector flow imbalances reveal to us in regard to sustainable growth trajectories? These are all timely and relevant questions that we all could stand to explore more deeply and openly if we are going to find a sensible way out of the recent mess without yielding to the default solution of simply creating more asset bubbles, which unfortunately appears to be the preferred path at the moment.