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Published on March 4th, 2012 | by Patrick Armshaw
Image © [caption id="" align="alignleft" width="563" caption="Easy Money - It's What We Need. © greensambaman"][/caption] The global financial crisis of 2008 is not over. The repercussions are still reverberating through the global economy, and have led to the nasty situation in which we find ourselves, with high unemployment (especially among the young), low rates of economic growth, rising deficits for governments around the globe, and a large debt overhang for individuals in many places. Back in October, David Cameron was roundly lambasted by economists and retailers for arguing that the solution to the first three problems lay in dealing with that last: that the way forward is for consumers to pay down their credit card debts rather than shopping on high streets. But why wouldn't this work? After all, if I owe money and have to pay to service that debt, doesn't it make me better off to save as much as possible, pay down the debt, reduce my servicing costs, and have more disposable income later? Absolutely! This would be a wonderful thing for me to do, all else being equal. The problem occurs when I'm not the only one doing so – if everyone follows my lead paying down debts instead of spending money, we all become worse off. To see why, we need to consider one of the more interesting and powerful theories in economics: paradox of thrift.

The foundation for this idea is simple: all my income comes from someone else spending money. If that someone spends less money, then I receive less income. If I spend less money, someone else receives less income. And, here's the kicker, if we all spend less money then we all receive less income. Think about what this implies: if I do what's smart for me, and so does everyone else, we all end up doing something stupid. And I wouldn't be any better off spending more individually – I'm still in debt and I still need to pay it off. This is what's known as a collective action problem – rational individuals behaving in ways that are collectively insane. We can't rely on individual action to solve the problem, because it's individual rationality that causes that problem in the first place.

So why would everyone stop spending? Firstly, they might want to pay down debt. Secondly, they might be worried about the future. What if I lose my job? What if my business loses money? This would make having cash on hand and in the bank a cushion against uncertainty. Thirdly, from a business perspective, what if I can't sell enough of my products to pay my workers, my landlord, and my investors? In all these cases, it makes sense to hold onto money instead of spending it. But if everyone does, then businesses lose money – and they respond by cutting production and firing workers. As unemployment goes up, the unemployed stop spending money (because they don't have any) and the employed start saving money in case they're next! Which in turn causes businesses to lose money – in other words, we get a destructive cycle.

So how can we get out of it? There are three main theories to choose from: the Monetarist, the Austrian and the Keynesian. The Monetarist answer is to use the Central Bank to lower interest rates: if this happens, then businesses can borrow more cheaply to invest, consumers can borrow more cheaply to consume, and workers can be hired back as profits rise and businesses expand. Sweet! Why on earth isn't it working? After all, the Bank of England and the Federal Reserve have both made a massive amount of money available to the banks by purchasing their risky assets – a process known as quantitative easing. Shouldn't all this free money mean banks are willing to lend to businesses at rock bottom rates? Firstly, this mechanism only works if interest rates are actually lowered – and in most advanced economies with their own currency (such as the US and the UK), interest rates are already effectively zero after inflation – meaning they can't go any lower. Secondly, who are the banks going to lend money to? Since consumers aren't buying, businesses can't make money expanding – and if they can't do that, then how would they repay even very cheap loans? Instead, that extra money has just sat in bank vaults – propping up banks without stimulating the wider economy.

The Austrian response is simply to let the recession do its work. They argue that the lower aggregate demand in a recession will cause prices and wages and rents to fall until equilibrium is restored – a process known as deflation. There are three reasons why this mechanism not only doesn't work, but actually makes things worse. Firstly, prices are sticky: wages are much harder to bring down than to bring up, because workers can't spend less without prices in the consumer market dropping first – and those prices in turn depend on how much it costs to pay workers to produce goods. Secondly, when prices fall, businesses respond by cutting production meaning that deflation ends up chasing its own tail; each fall in prices leads to uncertainty that necessitates greater falls in prices. Lastly, when prices fall the value of money increases – including money owed as debt. Deflation ends up making a debt crisis far worse by making debts larger, and making money harder to come by. All in all, not a nice strategy.

Finally, there is the Keynesian solution. If individuals cannot commit to spending enough collectively to get the economy started again, then the government has to do so, acting for all of us. The government is particularly well-adapted to play this role: it is able to shoulder far greater risk than any individual or institution; it is able to borrow and spend on a large enough scale that it doesn't need anyone else to do so as well; and the resulting debt can be paid back over the long run as the economy improves, tax receipts increase, and unemployment rolls shrink. The danger comes if this extra spending creates inflation, but that is deeply unlikely right now: serious inflation wouldn't occur until the idle resources in our economy (workers, capital and facilities) were put back to work. In fact, the inflation we're seeing today in Britain is primarily due to the hike in the VAT and increased demand for oil by developing nations – not from too much money in the system.

Essentially, what's needed is concerted government action to break the cycle of lower aggregate demand, increasing incomes and allowing the private sector to deleverage while the state picks up the slack. And while monetarist solutions can and do work, they require conditions that simply do not exist today thanks to the liquidity trap we're in. The only option left is Keynesian – and at the historically low interest rates available to Britain right now, we'd be fools not to take advantage. It also has the virtue of being the only method that has worked historically to heal an economy after a debt-induced recession – the Great Depression wasn't solved by austerity and interest rate cuts, after all. Instead of encouraging individually sound but collectively delusional behaviour, Cameron should be trying to figure out how to get people back to work, businesses back in business, and the economy back in gear. That, after all, is what government is for.

2

Prices, Debt and the Paradox of Thrift

Easy Money – It's What We Need. © greensambaman

The global financial crisis of 2008 is not over. The repercussions are still reverberating through the global economy, and have led to the nasty situation in which we find ourselves, with high unemployment (especially among the young), low rates of economic growth, rising deficits for governments around the globe, and a large debt overhang for individuals in many places. Back in October, David Cameron was roundly lambasted by economists and retailers for arguing that the solution to the first three problems lay in dealing with that last: that the way forward is for consumers to pay down their credit card debts rather than shopping on high streets. But why wouldn’t this work? After all, if I owe money and have to pay to service that debt, doesn’t it make me better off to save as much as possible, pay down the debt, reduce my servicing costs, and have more disposable income later? Absolutely! This would be a wonderful thing for me to do, all else being equal. The problem occurs when I’m not the only one doing so – if everyone follows my lead paying down debts instead of spending money, we all become worse off. To see why, we need to consider one of the more interesting and powerful theories in economics: paradox of thrift.

The foundation for this idea is simple: all my income comes from someone else spending money. If that someone spends less money, then I receive less income. If I spend less money, someone else receives less income. And, here’s the kicker, if we all spend less money then we all receive less income. Think about what this implies: if I do what’s smart for me, and so does everyone else, we all end up doing something stupid. And I wouldn’t be any better off spending more individually – I’m still in debt and I still need to pay it off. This is what’s known as a collective action problem – rational individuals behaving in ways that are collectively insane. We can’t rely on individual action to solve the problem, because it’s individual rationality that causes that problem in the first place.

So why would everyone stop spending? Firstly, they might want to pay down debt. Secondly, they might be worried about the future. What if I lose my job? What if my business loses money? This would make having cash on hand and in the bank a cushion against uncertainty. Thirdly, from a business perspective, what if I can’t sell enough of my products to pay my workers, my landlord, and my investors? In all these cases, it makes sense to hold onto money instead of spending it. But if everyone does, then businesses lose money – and they respond by cutting production and firing workers. As unemployment goes up, the unemployed stop spending money (because they don’t have any) and the employed start saving money in case they’re next! Which in turn causes businesses to lose money – in other words, we get a destructive cycle.

So how can we get out of it? There are three main theories to choose from: the Monetarist, the Austrian and the Keynesian. The Monetarist answer is to use the Central Bank to lower interest rates: if this happens, then businesses can borrow more cheaply to invest, consumers can borrow more cheaply to consume, and workers can be hired back as profits rise and businesses expand. Sweet! Why on earth isn’t it working? After all, the Bank of England and the Federal Reserve have both made a massive amount of money available to the banks by purchasing their risky assets – a process known as quantitative easing. Shouldn’t all this free money mean banks are willing to lend to businesses at rock bottom rates? Firstly, this mechanism only works if interest rates are actually lowered – and in most advanced economies with their own currency (such as the US and the UK), interest rates are already effectively zero after inflation – meaning they can’t go any lower. Secondly, who are the banks going to lend money to? Since consumers aren’t buying, businesses can’t make money expanding – and if they can’t do that, then how would they repay even very cheap loans? Instead, that extra money has just sat in bank vaults – propping up banks without stimulating the wider economy.

The Austrian response is simply to let the recession do its work. They argue that the lower aggregate demand in a recession will cause prices and wages and rents to fall until equilibrium is restored – a process known as deflation. There are three reasons why this mechanism not only doesn’t work, but actually makes things worse. Firstly, prices are sticky: wages are much harder to bring down than to bring up, because workers can’t spend less without prices in the consumer market dropping first – and those prices in turn depend on how much it costs to pay workers to produce goods. Secondly, when prices fall, businesses respond by cutting production meaning that deflation ends up chasing its own tail; each fall in prices leads to uncertainty that necessitates greater falls in prices. Lastly, when prices fall the value of money increases – including money owed as debt. Deflation ends up making a debt crisis far worse by making debts larger, and making money harder to come by. All in all, not a nice strategy.

Finally, there is the Keynesian solution. If individuals cannot commit to spending enough collectively to get the economy started again, then the government has to do so, acting for all of us. The government is particularly well-adapted to play this role: it is able to shoulder far greater risk than any individual or institution; it is able to borrow and spend on a large enough scale that it doesn’t need anyone else to do so as well; and the resulting debt can be paid back over the long run as the economy improves, tax receipts increase, and unemployment rolls shrink. The danger comes if this extra spending creates inflation, but that is deeply unlikely right now: serious inflation wouldn’t occur until the idle resources in our economy (workers, capital and facilities) were put back to work. In fact, the inflation we’re seeing today in Britain is primarily due to the hike in the VAT and increased demand for oil by developing nations – not from too much money in the system.

Essentially, what’s needed is concerted government action to break the cycle of lower aggregate demand, increasing incomes and allowing the private sector to deleverage while the state picks up the slack. And while monetarist solutions can and do work, they require conditions that simply do not exist today thanks to the liquidity trap we’re in. The only option left is Keynesian – and at the historically low interest rates available to Britain right now, we’d be fools not to take advantage. It also has the virtue of being the only method that has worked historically to heal an economy after a debt-induced recession – the Great Depression wasn’t solved by austerity and interest rate cuts, after all. Instead of encouraging individually sound but collectively delusional behaviour, Cameron should be trying to figure out how to get people back to work, businesses back in business, and the economy back in gear. That, after all, is what government is for.

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  • Mike Richardson

    If only Gordon Brown had been allowed to continue his Keynesian policies, as you mentioned it is the only theory that has a historical persistence in a recession of this magnitude. I fear that the current policy of Laissez-faire economics will lead to a lost generation.

  • Ian

    @Mike – I think we've already lost a generation, and we've been losing them well before the recession. Things are going to get a lot worse, and I can see most people in the 20-30 age bracket simply immigrating.

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