Monday, December 28, 2009

Keynes's Blind Spot: Consumption is Production Shared

Bret Stephens has written a nice opinion piece in the Wall Street Journal of December 23. He cites poet Rudyard Kipling and author George Melloan who wrote The Great Money Binge: Spending Our Way to Socialism.

Melloan's work, according to Stephens, shows "in exacting detail, not only how we came to our current crisis--thank you, Barney Frank, Chris Dodd, Alan Greenspan and Tom DeLay--but where [their flawed logic] is destined to take us again."

All four of these politicians--yes, Greenspan is one of them--seem to subscribe to Keynes's theory of what some have called "demand-side economics." This theory says that consumption is the answer to an economic bust cycle, and that it's okay to create the credit to pay for it through central-bank-created funny-money.

Stephens, citing Melloan I presume, and parodying Kipling, counters Keynes's theory using the supply-siders' argument:

"'[C]onsumption must be paid for with production" ... if you don't work (i.e. produce) you die (i.e., can't consume)."

[Thanks to for this image.]

Stephens and Melloan have understood the evils of Keynesian spending-for-prosperity, to be sure; but they have missed an essential point, which is this:

Consumption is purely a mechanism by which producers share among each other what they have already produced.

(See this post and the subsequent two posts for a more detailed example of this process.)

You see, production and consumption are two sides of the same coin, and production always comes first. One is given life by the other. Consumption cannot exist without production. We divide our production among ourselves on a global basis through the exchange among ourselves of small or large portions of what each of us has produced; and this action is called consumption.

We have gotten a distorted picture of this process, because often we see something we want and we think we have to work to procure the money to buy it. However, in reality the production of that thing came first, and the producers of that thing took their share of the product they produced by accepting a sort of warehouse receipt we have collectively come to label "money" instead of the produced thing itself. When we go to work, we simply become part of the exchanging group, much as a poker player buys chips to participate in the game.

Keynes obviously did not agree with this idea. He wrote as though he believed money has become a tool to be manipulated by politicians and their academic agents, as though it were a vague exchange medium representing nothing more than grease facilitating the performance of our monetary machine.

Like most people, Keynes also confused money (actual warehouse receipts, representing a share of production) with credit (a promise to repay a certain amount of warehouse receipts). Credit is not the warehouse receipt itself, but rather an expectation to receive warehouse receipt(s) within a specific timeframe, based upon the lender's faith that the creditor will hand over warehouse receipts in the short-term, when he or she has actually produced something and receives warehouse receipts as payment (or sells something he or she already owns).

Problems arise when credit promises are not fulfilled. For example, banks sometimes issue credit to market participants over and above producers' capacity to sell. Our current monetary system actually encourages banks to do so to an excessive degree, for reasons that I have treated elsewhere. (See this article, Page 1, Page 2, Page 3, for example.)

It is normal that at some point in every business cycle, banks will become overconfident and begin over-expanding credit by making bad loans. As a result, producers will manufacture (and sellers will purchase, stock, and try to sell) excess production. Under a healthy banking system, slower sales cause sellers' inventories to rise. As a result, they stop ordering, producers stop producing, and things return to their original equilibrium.

However, in an imbalanced banking system, credit starts to circulate, which means that buyers keep buying, profits keep rising, and sellers keep selling at higher and higher prices (too much money chasing too few goods). Producers receive increasing orders and on that basis get even more credit from the bank. They hire more workers, creating a misallocation of labor.

Then, with profits rising inordinately, a speculator instinct wakes up inside some otherwise normal businesspeople. These market players realize that instead of working, they can make lots of easy money borrowing credit, gambling on the stock market, betting on derivatives, playing the foreign-exchange gambit, or flipping real estate, i.e. making fast profits producing nothing.

Bad credit begets bad credit in an ever-climbing spiral. The boom game has begun, misallocating huge sums of what appears to be real money (warehouse receipts), but which in fact is only bad credit.

Then one of the sectors hits a snag. Very often it starts in the financial sphere when someone over-bets his credit. He can't pay; the bank calls his loan. His creditors don't get paid. When this mini-bust occurs, it infects other sectors that depend upon the flow of easy credit collateralized by real or imaginary profits.

Much misappropriated "wealth" just disappears into thin air, which is actually where it came from; but unfortunately ordinary people also suffer as producers of speculative production go bankrupt and misallocated workers lose their jobs.

Fearful people stop consuming until the bad credit is gone and equilibrium returns. This is the normal process, and if left alone it can take several painful months to wind itself down.

But Keynes and today's central bankers think they can outsmart the process. I can hear Keynes say, "Wait a minute. The warehouses are full and people are simply not buying. The wealth seems to be there, because production has already taken place. Somehow, the 'warehouse receipts' have been stashed, or misplaced, or destroyed by the bust mechanism, and all that is needed is for the central bank to prime the pump."

What he doesn't realize is that this Keynesian "solution" just creates more bad credit and throws it at consumers who--quite properly--just don't want to consume. This time, bad credit comes from both the Federal Reserve and the Treasury in the form of zero-interest loans, "stimuli," government purchases of private companies like AIG, and bank bail-outs, which further misallocates money distribution away from the real economy (that can't absorb it) and towards the speculators who know how to play what has now become a funny-money political game. While this is going on, the serious participants in the economy are laying low with uncertainty, wondering what the Fed, the Treasury, plus the IRS, Congress, the EPA, and all the other alphabet agencies, will do next.

Kipling, Stephens, and Melloan seem to understand this game and have tried to call the politicians' bluff. But the politicians will ignore them, because they have found they can fool most of the people most of the time, and a few they can't fool can be bought.

And this game of Pied Piper goes around and around until the people take back control of their money. And they are doing so, through the purchase of gold, gold-related instruments, and other such store-of-value investments. Hopefully, they will not let the government take that right away from them.

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