The World According to Smith

235 years ago, modern economics was born when Adam Smith wrote The Wealth of Nations. Smith gave us a model of national wealth that grows through the efficient use of land, labor and capital.  He believed that the best way to achieve this growth was through the "invisible hand" which magically guides free markets.

Smith wrote his book in 1776, the same year as the birth of  our nation.  It was at a time when Monarchies first started losing to the modern nation-state, and industrialization had just started to ramp.  By embracing the free market philosophies of Adam Smith, capitalistic societies were able to rapidly expand throughout the world, growing along with the dramatic changes brought about by industrialization.

As successful as the free market was in expanding capitalism and industry, one nagging little problem kept cropping up.  Every once in a while, the invisible hand would break down, and the free market would stop working.  This was especially troubling when the result was prolonged unemployment for the new industrial worker -- a worker who needs a job to keep a roof over their head, and food on their table.

The World According to Kondratieff

While many people saw recurring cycles in the economy, most believed the pattern was simply a mild business cycle that recurred every 4 years or so.  Some did recognize a longer cycle that lasted around 11 years, but there was no consensus on why this might be the case.

Then, in 1926, three years before the Great Depression, Nickolai Kondratieff wrote a paper titled "Long Waves in Economic Life." He was one of the first to observe that capitalistic economies undergo decades-long cycles of inflation, followed by deflation. Today, his observations are known as the Kondratieff Wave.

The World According to Keynes

While Smith espoused free markets, and Kondratieff recognized and predicted the "long wave" result, John Meynard Keynes decided to study historical panics, recessions and depressions, with a special focus on unemployment.  In 1936, he wrote The General Theory of Employment, Interest, and Money, and Keynesian economics was born.

Keynes gave us a model of the economy that, for the first time, included a framework for governments to actively participate in the business cycle.  Instead of solely relying on the invisible hand to manage free markets, governments were now empowered with fiscal and monetary policies that they could use to mitigate recessions and depressions.  His model worked so well, that by the end of the 1960's, almost every western nation had adopted Keynesian economics.

When I studied economics in the late 70's, the professor was Denslow, the textbook was Samuelson, and the concepts were Keynesian.  While Keynes had worked for 30+ years, the Keynesian model seemed to stop working in the high inflation, high unemployment environment at that time.  As Keynes lost favor, so called "supply side" economics came on the scene, eventually to be replaced with a return to the free market ideology prevalent under Smith.

It is that free-market ideology that has brought us again to the brink.

The World According to Batra

I first learned of the long wave back in the early 80s, and I'd been expecting what is today known as the Great Recession ever since.  Because of this, in the late 80s, I read a book titled The Great Depression of 1990 by Ravi Batra.  While his timing was a little off, his insights into the causes of market failures were spot on, and describe perfectly what's going today.

According to Batra, the reason markets break down, is that capital gets accumulated at the top, and ceases to circulate in the economy.  When the bottom of the wealth pyramid collapses, those people at the bottom have nothing left to spend, and the low end of the market freezes.  Then, when those who sell or otherwise depend on the low end of the market start to lose their income and wealth, they stop spending as well. This leads to a general market failure, as money is taken out of circulation, and the market failures spiral upward.

We can see this today.  Recent poverty numbers confirm that many former members of the middle class, have now entered the ranks of the poor.  Many people have lost their life savings, their retirement, and their homes.  Those who depend on these people (the retailers, the taxing authorities, etc.) have seen their income evaporate as well.

At the same time, those at the top have been hording money.  We can see this in the estimated $2 Trillion held by large corporations, that they are not investing in factories or employees.  We can see this in the many Trillions more on the books of the big banks, that they are not lending to borrowers.  So long as there is not an expanding market for goods and services, they will continue to sit on their holdings.  Instead, they will seek the highest returns possible by speculating in commodities and financial products, or by bribing Congress for tax breaks and more corporate welfare.

Public Policy Response

When the housing bubble burst and the markets froze in 2007, our leaders turned to Keynes for a response.  That's why the U.S. Government authorized the $900 Billion stimulus plan.  That's why the Federal Reserve has injected over $1.5 Trillion into the system.  And that's why foreign governments have injected Billions of Euros into their system as well.

Unfortunately, they did all this without acknowledging nor addressing the real reasons for the market failure.

Today, this folly continues.  How many times have you heard someone say that Americans must be retrained with new skills to be competitive to find a job?  How many times have you heard someone say that we must invest in new industries, to create jobs and be competitive in the world markets? None of these address the real problem -- a lack of demand for goods and services, caused by a lack of capital in the low end of the market.

The Real Way Forward

If we really want to end the Great Recession, the prescription is simple.  Stop putting money in at the top of the pyramid, and put it where it will make a difference and start the spending again.  Instead of giving $900 Billion to the banks, instead of borrowing $1.5 Trillion from the Fed to support the too big to fail, instead of spending $447 Billion on a jobs program that at best will create 1 million jobs, give it directly to the people, and cut out the middle man.

Consider this.  If we conservatively estimate that the entire amount of money spent through fiscal and monetary policy to prop up these too big to fail institutions, it is approximately $3,000,000,000,000.  If instead, we issued a check to every man, woman and child in this country, each person would receive approximately $10,000. That's $40,000 for a family of four.

With this type of Keynesian stimulus, our economy would be humming again.  And those too big to fail institutions would be gone, and no longer a problem.  I know this one will ruffle some feathers, but as always, comments welcome.  Until next time.

"According to the Central Intelligence Agency, income distribution in the United States is more unequal than in Guyana, Nicaragua, and Venezuela, and roughly on par with Uruguay, Argentina, and Ecuador. Income inequality is actually declining in Latin America even as it continues to increase in the United States. Economically speaking, the richest nation on earth is starting to resemble a banana republic."

"from 1980 to 2005, more than 80 percent of total increase in Americans' income went to the top 1 percent. Economic growth was more sluggish in the aughts, but the decade saw productivity increase by about 20 percent. Yet virtually none of the increase translated into wage growth at middle and lower incomes, an outcome that left many economists scratching their heads."

Here Come the Currency Battles
At the root is an unwillingness on the part of major Western economies to let the prices of certain asset classes--especially real estate in the U.S., and bad bank debt in Europe--find their actual value. In that sense, the notion that governments are protecting Big Finance and other powerful lobbies from the consequences of betting on a bubble is true.

The Federal Budget Fiasco
If we do not increase the federal budget limit, we will immediately be forced to balance the budget (no constitutional amendment required). In August, the government is expected to collect about $172 billion in revenue, and will face about $307 billion in expenses. That will leave us with a $135 billion shortfall.

We only need to cover about about $30 billion in interest to avoid a default on our debt. It will be interesting to see who the government chooses to pay, and from whom it chooses to withhold payment.

Does Washington have a spending problem or an income problem?
Washington's spending has recently been higher as a percentage of the nation's economic output than at any time since World War II. But by the same measure, Washington's revenues are the lowest in more than 60 years.

What's at stake in the debt-limit talks: a primer
In August, the government is expected to collect about $172 billion in revenue and will face about $307 billion in bills. So, the government would have the money to pay a little more than 55% of its bills during the month. But which bills to pay? Interest on existing debt comes to just under $30 billion, Social Security checks are $50 billion, Medicare is another $50 billion, payments to military contractors for weapons, fuel and other costs comes to $32 billion and salaries for active-duty military personnel come to about $3 billion. Add in unemployment benefits ($13 billion for the month), and the government would already have run out of money without paying a single civilian employee or running any of its domestic programs, including courts, disaster relief, national parks, veterans benefits or welfare programs.

Economic Armageddon and You

Walmart Supreme Court Sex-Bias Case: Too Big to Sue?
Some of the worlds biggest corporations were protected from bankruptcy at the end of the financial downturn by a policy dubbed “Too Big to Fail”. Now we have a ruling from the US Supreme Court that has dubbed one large corporation “Too big to Sue” that may have a significant impact on future plaintiffs ability to initiate class action suits against large corporations. (Editor's Comment: Every woman who feels discriminated against by Walmart should walk over to their superior court, and file suit against Walmart without an attorney (pro se). Once Walmart faces thousands of these individual suits, they will beg the court to convert these claims into a class action.)

The Long, Slow Death of Debt
If too much debt caused our financial crisis, getting rid of it is the solution.

Robert Reich (The Truth About the American Economy)
The U.S. economy continues to stagnate. It’s growing at the rate of 1.8 percent, which is barely growing at all. Consumer spending is down. Home prices are down. Jobs and wages are going nowhere. It’s vital that we understand the truth about the American economy.

http://news.yahoo.com/1937-feeling-over-again-190218704.html

Federal Reserve Chairman Ben Bernanke, an expert on the Great Depression, once promised that the central bank would never repeat its 1937 mistake of rushing to tighten monetary policy too soon and prolonging an economic slump.  Back in 1937, the U.S. economy had been growing rapidly for three years, thanks in large part to government programs aimed at ending the deep recession that began in 1929.  Then the central bank clamped down hard on lending, and federal government spending dropped 10 percent. The economy contracted again in 1938. The jobless rate soared.

Full employment is one of the Fed's prescribed goals, and it is clearly falling short. Government spending cuts are making matters worse.  Friday's employment report showed a net loss of 37,000 government jobs last month.  State and local governments with balanced budget rules had little choice but to cut jobs in order to make ends meet.  The federal government has no such restriction, but its spending outside of defense fell at a 7.3 percent annual rate in the second quarter, crimping economic growth.

Money Creation and Destruction

The first thing to know about our money supply, is that every day, millions and millions of dollars are created.  At the same time, millions and millions of dollars are destroyed.  The most obvious example of this is the way old, worn out dollars are destroyed, with new dollars printed to replace them.  Historically, the amount of new dollars printed has exceeded the amount of dollars destroyed.  This shows up as an ever increasing amount of dollars in circulation.

Just like physical money is printed and destroyed, electronic money is as well.  To understand how this works, it is helpful to realize that money = debt.

Money = Debt

If we pretend to live in a world without money, and we ask the U.S. Government (USG) to pay us $5, they would walk over to their printing press and print a $5 bill.  When the USG gives us that bill, we are now $5 richer, and the USG now has an outstanding obligation to provide $5 worth of goods and/or services to anyone who presents them with that bill.  In other words, the USG has just created a $5 debt obligation.

When that money is returned to the USG, it then has the option to spend it again (roll over the debt), or to keep and/or destroy that money (retire the debt, and decrease the money supply).  To summarize, anything the USG does to print or borrow money creates more money, and anything the USG does to retire its debts destroys money.

The Role of Interest, Taxes, Bankruptcy and Default

Normally, this process of creating and destroying money would be a system in equilibrium.  However, with the imposition of interest expenses, our money supply is guaranteed to ALWAYS be constrained.  You see, money created will circulate until it returns to its source and is retired.  However, if interest is charged on the money that has been created, that interest payment must come from someplace.

Using our prior example, if the $5 we received from the USG was lent out for one year at $1 interest, there now exists $6 in obligations.  Where did the extra $1 come from?  How was it created?  Easy answer is that it doesn't exist, and it wasn't created.  The person who now owes us $6 must borrow an extra $1 to pay us back.

Another major drain on our money supply is federal taxes.  While it's true that some taxes are used to redistribute money from one stakeholder to another, there is also some amount of taxes that are used to retire debt.

These drains on the money supply guarantee that money will always be constrained, and ensures that extra debt obligations can only be eliminated through bankruptcy or default.

Putting this all together, here are the major sources of money creation and destruction:

Summary

Today we've covered the assorted ways that money is created and destroyed, the role of the U.S. Government in the process, and why bankruptcy and default are built into the system.  Next time, we'll look at the National Debt Limit, the role of the Federal Reserve, and alternatives and consequences to our current system.  As always, comments welcome.  Until next time ...