The current recession has brought to the fore two key schools of thought regarding economic policy, in a rehearsal of earlier and probably ageless debates. One school is Keynesian and the other can be called an ‘Austrian’ viewpoint because many of its founding figures in fact studied and theorized in pre-war Austria.
The main purpose of this essay is to discuss whether it makes sense for the government to spend money in excess of tax receipts (i.e. to borrow and spend) in the midst of a recession. But I need to start with the concept of money. Anyone worried about central banking and gold, and in need of some clear exposition, has come to the right essay. Be warned that if you came here to discover why gold makes more sense than paper money, you’ll be disappointed. But I hope at the very least you’ll find something worth thinking about.
Reasonable people disagree about the concept of ‘money’. For me, money is a transactions device. Humankind need it to carry out business — to fulfil their inclination “to truck and to barter” as Adam Smith put it. This is a statement about what gives money value. It’s a hugely debatable question and the key to disagreement between Keynesians and Austrians. Many people would at this point hasten to add that money serves as a “unit of account” and a “store of value”. These are not un-true but they do not account for money’s value to society; it’s really the transactions function which money satisfies that gives money its value. This matter was settled by an obscure legal scholar named Arthur Nussbaum in the mid-20th century, in my view.
Someone of the Austrian persuasion would disagree completely, and say that money as we know it has “no value” and is just intrinsically worthless paper. They would say that only gold is money and this paper stuff is a huge fiction and, worse, a con. I acknowledge their fervor around this issue, but fervor alone does not make their argument correct. In fact, their confusion around money is profound: whereas they think only gold can give value to money (e.g. when gold is used directly as money or when gold is officially convertible into paper money at a guaranteed rate, as in the ‘gold standard’), in fact it is money which has given value to gold. Gold’s intrinsic usefulness is much less than would explain its value were it not for its monetisation.
Money is intrinsically valuable because it satisfies a transactions utility among the participants in the economy. If you can accept this point, then I’d like you to consider a further one: falling prices and wages present an especially difficult problem. For the Austrian viewpoint, it is absolutely crucial to believe that falling prices and wages are not a problem; both schools agree that there will be falling prices and wages in the circumstances of a “de-leveraging” recession of the type we’re seeing today, which is the kind we saw in the Great Depression.
What I mean by a de-leveraging recession is a recession where the private sector overall is trying to reduce its debt. This has a big implication for the supply of that useful transactions-technology called money. Most ‘money’ is debt. People of the Austrian persuasion are up in arms about the US central bank — the Federal Reserve — creating money (I think Texas Governor Rick Perry just recently criticized the Fed for creating too much money). They seem oblivious to the fact that ‘money’ in the economy is comprised of many things, most of it created by the financial system itself and very little of it created by the Federal Reserve. I’ve written about the difference here. In fact, the Fed’s actions to expand money are like King Cnut holding back the tide: swamped by the great de-leveraging of the private sector. (Again: most money is not that stuff created by the Fed, but the stuff created by the financial system, i.e. the credit it writes.)
This contraction in the money supply necessarily creates downward pressure on prices and wages. If we have the same amount of ‘stuff’ (including services) but less money, then the money-per-stuff amount must by definition be less. That’s deflation. But recall what I posited about deflation being especially problematic. We just don’t work with it very well. Daylight savings time provides a useful analogy (hat tip to Milton Friedman). Why don’t we all just agree to wake up earlier in the summer rather than set our clocks forward by an hour? Because it’s hard to organize. Consider someone selling a house today. They paid x amount for it a few years ago. They’ll take a little less now, but nothing like the discount which the market demands to clear the transaction. They might take a 25% discount if they know for sure the person over in the next state (to which they are moving) will be offering a 25% discount. But who’s going to organize such a thing?
It’s even worse. What private debt is contracted to take account of falling prices and wages? The store owner who cuts her prices is going to make less money. Does her bank reduce the amount of debt owed by her? No. Do her employees take a pay cut? Actually yes they do. But they can’t afford to take a pay cut that’s big enough to make their employer whole — because their own mortgages and other personal obligations won’t be cut by the bank to account for their new, lower salaries. So these workers become too expensive for the store owner.
Here we are in a great dysfunction of the capitalist economy. The private sector is racing to cut its debts, and in the process is shrinking the money supply. The central bank is impotent to expand the money supply because in a modern financial system most money is created by the financial system. And anyway blowhards like Rick Perry are threatening violence against the central bank for the little it is doing, completely oblivious to the fact that Ben Bernanke, the central bank chairman, is mostly powerless to stop what’s happening.
What to do? There are four spending streams in the economy: two in the private sector (households and businesses), the foreign sector and the government. We already agreed that households are paying down their debts, which is creating the downdraft in the money supply in the first place. The Austrians think business spending will make up for it. But why would the corporate sector invest in new projects when the outlook for demand is so poor?
How about the foreign sector? Well actually this could be part of the answer. But for this to happen we need a much weaker currency. To see the difficulty in actually achieving this, consider the exchange rate as an outcome of the relative supplies of two countries’ monies. If the US money supply if falling, then this is bullish for the dollar. (And this is why, whenever the markets get confused about the Fed creating ‘too much’ money and the dollar sells off, smart people should buy it.) Some (including Austrians, I would think) believe a country can achieve a big improvement in the export position without a change in the exchange rate. But this is fanciful — trade usually follows price differentials; exchange rates are key to relative prices. So it’s hard to see how we can get a big trade surplus without a more competitive currency (the foreign markets are there — i.e. the emerging markets, which are not in the mess we’re in). But we can’t get a more competitive currency because our money is becoming more valuable as there is less and less of it, and because the dollar is not really a free-floating currency, considering that a big share of US trade partners peg their currency to the dollar.
As you may have guessed, this leaves only the government sector able to fill the vacuum created by the de-leveraging household sector. It can do it in these circumstances at a cost lower than almost any other time in the normal life of a capitalist economy. On one hand, nobody else is borrowing, which makes it cheaper for the government to borrow. On the other hand, because these deflationary forces are making private-sector debtors a pretty risky proposition, there is periodic urgency to invest only in the most reliable borrower: the government. In other words, there is great demand for the very bonds that the government would issue if it were to borrow more. Altogether it makes vast sense for the government to step into this situation and keep the economy afloat, and this is a point which became clear to JM Keynes in the 1930s but was not understood more widely until after WW2.
Keynesianism acquired a bad name eventually because governments used it at times when the malady did not fit this cure, i.e. when there was already plenty of inflationary pressure, when resources were not lying idle being ready to be called into use, but instead when there was a dearth of spare capacity and any extra government spending only exacerbated inflationary pressure. Today is not one of those times. It’s a time like the 1930s, when there is idle capacity, when there is a lack of demand to call into use the idle humanity and machinery of the economy. There’s plenty the government could invest in as it spends this borrowed money. And these projects could easily pay for themselves in the sense of providing ‘public goods’ to the economy which otherwise are difficult to provide. Infrastructure comes to mind, of all sorts. And schools, teachers, classrooms.
The irony here is that Austrians and Keynesians both see the outlook as dim. For Austrians, the Fed is creating too much money. For Keynesians, the Fed is basically powerless to create money of the sort that circulates in the economy, and the one sector which could do this — government — is cowed into believing that it can’t. For someone who’s recently earned a PhD in the monetary dimensions of the 1930s (me), this is all very saddening.