Money is not Wealth

Money and Wealth

Wealth is stuff. Wealth is genuine value, it is something you can use. It is the car in your driveway, the knowledge in your head, the clothes on your back, and a factory that can make these things. To make more wealth takes tremendous effort. As a nation we improved our wealth stock in the lead up to WWII, and we destroyed plenty of wealth in the war itself, but neither of these events were easy. 2008 did not see much destruction of wealth, and yet suddenly everybody got poor. This is because suddenly there wasn’t enough money.

See, money isn’t wealth. Money is paper with dead presidents on it, and numbers in an account. Money is easily exchangeable for wealth (I can go to the store with a $100 bill and get a big bundle of real stuff in return), but at the end of the day, my money is neither food, nor shelter, nor entertainment. What money does for us is lubricate the economy. Money is what lets us buy and sell, it is a useful intermediary for us to use to exchange wealth, and right now we don’t have enough. The recession didn’t make the factories we had, the knowledge we had, or the cars we had, any less good. These things did not lose any value: the average worker did not suddenly become dumber or less useful. What the average worker suddenly did not have was money. Because suddenly people had less money, the lubricant of the economy dried up, and just like an unlubricated engine, it seized up.

More specifically, the money did not go away, but like in an engine with a broken oil pump, the money ceased to be where it needed to be, and instead congregated in the banks, languishing in the metaphorical oil pan rather than being distributed among the moving parts of the economy. As long as there is insufficient money among the moving parts (you and me, to be specific), the motor will run haltingly, and people will continue to want for money, but more importantly, they will want for real wealth, living in apartments that are too small, driving cars that are too old, and in the worst cases, going hungry.

The important thing here is that people are going hungry not because we do not have enough food, farms, and factories, but because of a shortage of money, which we can print as easily as we like, on demand. People going hungry for want of wealth is sad, but people going hungry for want of money is a tragedy of epic proportions, because it is one that we could fix tomorrow, simply by printing a stack of $100 bills and mailing them to each citizen.

Maybe somebody ought to think about doing something.

Tale of Two Recessions

My father in law made a reference to the recession of the early 80's, and how Regan's sunny optimism helped end it.  Optimism may count for something, but the recession in 1980 was entirely different from the more recent one, because in the early 80's, Volker took the real interest rate up as high as 15% (Which is impressive, because that is over and above the high rate of inflation), and then when he decided that the economy had suffered enough to bring inflation back under control, he brought the real rate back down to reasonable levels.  

Blue is the Fed Funds-Inflation, which is a rough estimate of the real interest rate

The real fed funds rate went up, unemployment followed shortly thereafter, and then the fed funds rate went back down, and unemployment came back down to a healthy level shortly thereafter.

Compare to the last 7 years (Same graph, different time):

Blue is the Fed Funds-Inflation, which is a rough estimate of the real interest rate

We have an entirely different story here.  At the beginning of 2008 the housing market fell apart, and to try to contain this disaster, the Fed dropped the rate to roughly zero in nominal terms, but that was not enough.  Whereas in '82 the Fed caused the recession by raising rates and ended it by bringing them back down, in '08, the tried to avert a recession by bringing them down, and by the time things got really bad, it couldn't bring them down any lower.  If the fed funds rate could fall further into negative territory (ie, if inflation were 5% rather than 2%), the Fed would have a lot more room to maneuver and bring the economy back up to speed, but... nope.  Instead the Fed's first line of defense is out of steam because of the zero lower bound, which is what my intro econ class (ECON 5 for those at Tufts) called a liquidity trap.

So, please, somebody.  Explain to me why targeting inflation at 5% rather than 2% would be a bad idea!  Because if the best reasons out there are the reasons I've heard, which so far boil down to "Inflation is hard to control, and bringing it back under control requires causing a recession, which would cause unemployment," the econ 101 textbooks of 2040 are going to judge us harshly.  

The most pressing economic problem of our time is high and lingering unemployment, and to not fix it because the cure might entail some unemployment later is the height of absurdity.  It is roughly akin to telling a patient with gangrene that they won't get antibiotics, because they might help breed a resistant strain.  The possibility of a 1982 style recession in the year 2020 is a terrible reason to push us through what might well end up as a decade of high unemployment and anemic growth.

I feel like this is being made more complicated than it needs to be

Everybody, anywhere on the political spectrum, says that the economy sucks because business investment is low.  Business investment is low because the economy sucks SO MUCH that cash is an appealing investment, because it is 100% sure not to lose value at any less than the rate of inflation (this is the heart of a liquidity trap).  If we make cash a less appealing investment by raising the rate of inflation, businesses will invest more in the economy.

There it is, my 3 sentence argument for targeting an inflation rate of 5% instead of 2%.

Side benefit of raising the inflation rate?  Every pre-existing mortgage becomes more affordable, every pre-existing car payment becomes more affordable, every pre-existing student loan becomes more affordable, and wealth is transfered from the big guys who have the cash, to the little guys who owe money.

Human Suffering

While I at times argue detailed and lengthy economic points, my position is simple:
When nearly 1 in 10 people who counts themselves in the work-force is out of work, hiring people and giving individuals money with which to hire people will reduce unemployment and human suffering.  Further, I believe that when we have the opportunity to borrow that money at rates below the rate of inflation (meaning that in real terms every dollar spent today will cost less than a dollar to pay back when the loan comes due in 10 years), it is a moral imperative to feed the hungry now and pay for it when the economy is once again strong.

I can talk for hours about aggregate demand and sticky wages and macroeconomics, but the core of it is simple: People are hurting, and we can make it better.  Every day a child sits in an over-crowded classroom while last-year's teacher sits at home because they were laid off is a waste, pure and simple.  We can fix this, we can fix it now, and to do otherwise is a crying shame and a human tragedy.

To argue otherwise seems to requires at least one of three implicit assumptions:

1) In current conditions, government laying people off does not raise unemployment and government hiring people does not reduce it.

OR

2) To make the suffering better with a borrow-and-hire strategy would have negative consequences that are worse than the current suffering.

OR

3) The current suffering serves an important purpose moral purpose, and to subvert it would be to upset some natural order of things.

In times of full employment, number 1 has solid traction: crowding out through interest rates and labor costs is a real phenomenon.  With interest rates stuck at zero only because anything lower makes no sense, and employees scrambling for jobs already, these arguments hold little water.

Number 2 has many potential sub-types, but with current suffering so bad, and interest rates so low, its hard to find a reason to justify letting Americans go hungry.

As for number three: If you do not live in poverty (15% of the population, $15 per person per day for a family of four) then its not your morally righteous suffering to defend.

Economics As a Science

Scientists come up with an idea of how the world works, compare it with real evidence of how the world works, and then if the idea about how the world works fits the evidence well enough, then they publish a paper explaining their idea and why they think it is a reasonable description of how the world works.  For instance: my wife did her senior thesis looking at the role of a particular gene is involved in the leg development of a particular bug.  Her idea about how the world works was that this gene was needed, and she tested it by blocking expression of the gene, and observing that the legs did not develop.  An economist would say that her model of how the world works looked like this:

She thinks this is a reasonable model, because when you block the step in red, you don't get leg development. This is also how economics is supposed to work, and it is how it generally does work.  The model is usually a little more complicated than this, because there are a lot more moving pieces. Still, the model could be as simple as this:

Which with only a little bit of math and thought gives us this:

This is the model of supply and demand, it has a TON of evidence behind it, and it is the idea that prices shift until there is as much supply as demand. This is called markets "clearing" (because there is nothing left unsold), and it is the basic model that economists fall back on to underly everything.  It is to economics what F=MA is to physics.

Further, we can understand a lot of the world of economics by using variations of this on this idea, so much so that its easy to get the idea that we really understand what is going on here.  But there is a catch.  Like F=MA, this is true, almost.  Just like F=MA does not explain everything in the universe (F=MA stops working when you have really big and fast objects), models based on markets clearing also fail in particularly weird cases.  Like recessions. Specifically, the market clearing explanation of recessions, the Real Business Cycle theory, does not include real, involuntary, unemployment.  Seriously, the wikipedia page linked literally does not mention unemployment.

And so we are left with two major camps of economics:  the ones that base all of their work off of the assumption that markets clear, and the ones that relax the market clearing assumption, and come up with a model of how the world works that explains our current experience.  The ones who did the former can be found in the pages of the Wall St. Journal, and the ones who did the latter trace their conceptual roots to Keynes.

With unemployment running at 9.1%, I think we can agree that the evidence pretty profoundly discredits the market clearing models, which leaves us with only one major group of models about how the economy works, and they all say some variation of: "Stimulus, for God's sake the government needs to borrow and spend!"  If you are against stimulus, I challenge you to carefully lay out an explanation of how we get unemployment.  I'm not saying an exact description of the world, I'm just saying a sort of story, like the bubbles for supply and demand, that explains why we have unemployment.  As an example, here's mine:

Consumer Confidance

Jacques is nothing if not confidant.  He seems always confidant he can take on another dog in a fight, always confidant that I will re-fill his food bowl, and always confidant that when I come in the front door it is because I want to play with HIM.  Perhaps his overwhelming confidence that I will continue to feed him and give him treats is why he never saves for later.  This is also exactly how consumer confidence works.  If consumers are confidant, they spend, if they're less confidant, they save, which is why when a pundit on NPR not long ago said this: "the economy needs consumer confidence to come back, it will recover when consumers start spending again," I asked myself "spending what money?"

It is not a psychological quirk that is making the average consumer try their best to spend less than they earn (my explanation of what impact that has here, Krugman's careful model of how that works in this paper), they are trying to save money because their combination of debt, assets and rational economic outlook make saving the only sane choice.

With the economy the way it is, asking people to spend instead of save, that is asking to take on yet more debt, is both impractical, and more importantly a really bad idea. Remember that the economy took a dive because people realized all at once that consumers had too much debt, and couldn't repay all of it. Asking them to shut their eyes, pretend like they didn't realize that, and pull out their credit cards would only set us up for another 2008. This recession will get better when there is a way for the private sector to get out of debt, whether it is through inflation that makes the debt worth less, default in which the creditors just get hosed, or through expansionary fiscal policy in which the government borrows so the private sector can save, giving us new infrastructure ad a side effect.

Until that happens, I only foresee more malaise, and my biggest fear for the economy is that, like Japan, the whole world will see a "lost decade" that could well drag on for 20 years or more.

Saving the Economy

Jacques doesn't get savings and investment.  I've never seen him store a bone for later, and he doesn't seem to have any conception that he might want to save something up.  Which is fine, because he's a dog, he's not supposed to get how savings works.  But I realized that the concept of savings is something I don't think much about either. When I do, it is usually an issue of how much I have saved in the bank, but stopping to give it more thought, its actually a lot more interesting.

The reason it's interesting is that every single dollar that every single person has can either be consumed, or invested. Because dollars represent real wealth, some valuable service or product, it has to be somewhere.  If its a physical good, it can be sitting in a warehouse, or it can be a gizmo helping an assembly line run, but it has to be somewhere. If it's a service, for obvious reasons it has to be consumed on the spot. Because really, you can't "store up" an oil change or a manicure.  What this means is that every dollar's worth of wealth created must be either consumed or invested.

Another important way to look at it is this: every dollar that you save is really a dollar that you're lending to somebody else. Even if you're just stuffing dollars bills into the mattress, those are effectively IOUs for goods or services that you'll buy back later. The problem with this is that if I'm saving, somebody else has to be borrowing, which means that not everybody can save money at once. If my balance sheet gets another dollar into the black, that means somebody else's just got another dollar into the red.

Normally this is just fine. If people in general decide they want to save more, the supply of bonds goes up and banks have more money to loan, which means that the terms for saving get less favorable for the savers (you bank pays you less interest) and more favorable for the borrowers. This makes more people willing to borrow, since the rates are a bit nicer, and less people want to save, since the rates are a bit less nice. In other words, the interest rates are the price of money, and the price will shift until the supply of money equals the demand of money. Obviously, the situation is more complicated than this, but its really not that much more complicated. Your personal decision about how much money to save or borrow is influenced by interest rates, and the interest rates shift until there's exactly as much desire to save as there is to borrow.

Here's where it gets tricky though. Sometimes, everybody gets scared, and wants to save. Something happens, and everybody realizes all at once that they're not saving enough (maybe the house that they were counting on getting them through retirement just became worth less than their mortgage). In normal times, this would be accompanied by a downward shift of interest rates until somebody wanted to take their money and spend it, often by investing in a business. These are not, however, normal times.

Because very quickly, in 2008, we discovered that interest rates have an inherent lower bound. They cannot be significantly less than zero, because stuffing cash in your mattress is effectively saving money at a 0% interest rate. What this means is that, if a 0% interest rate is not enough to get people investing, then people just won't spend or invest everything they earn. Which cannot happen.

What can happen is that the total amount of wealth created drops (and people get laid off) until people once again spend everything they earn, but now because they have to (groceries and heating bills are pretty much unavoidable). This is what's called a liquidity trap—everybody wants safe, or "liquid" assets all at once, and the interest rates cannot go lower than zero, so they can't be convinced to put their assets into riskier investments. There is a shortage of liquidity, and this is what happened to Japan around 1990, after which they had a span of anemic growth and bad times for their people. When the economics textbook on my shelf was published, this was called their "lost decade," though as it continues into roughly year 18, its hard to know exactly what to call it.

What this means for our economy today is this: there is not nearly enough spending, we cannot ask individual households to spend, since they are already in risky fiscal positions, and without being able to lower the interest rate further, businesses are unlikely to invest either, given the terrible economy they face. So, to fix this, we need to do one of two things: All agree to invest at once, or find a way to lower the interest rates below zero.

If we all agreed to invest at once, it would work out great for everybody. We'd get the stuff that we bought (I suggest things like fire trucks, schools and water systems), and once the economy picked up again businesses would be more willing to invest and borrow, which would let consumers save, allowing us to go back to "normal times." This option is, of course, government spending, in which we all agree to borrow money at the fantastically low rates the government has available (2.17% for a 10 year loan as of Wednesday) and spend it on things that need fixing, like our abysmal school and elderly water distribution system.

The other option is to find a way to further lower interest rates. The reason that this is possible is that nobody really cares about the nominal interest rate, they care about the interest rate compared to inflation. What that means is that the real interest rate, that is the nominal rate less the rate of inflation, can be less than zero. So, if we had some solid inflation, perhaps 4%, we would have room to make real interest rates negative, which would encourage investment and spending, which would, at the very least, lead to full employment.

Either one of these options would help the economy. The government spending option has the huge advantage of leaving us with better roads, water systems, and schools, as well as avoiding the risk of another housing bubble style side effect of low interest rates.  However, as a young person with a bright red balance sheet myself (school was expensive), I'd be happy with either option, because both would make it much more likely for me to spend the next decade with a good job.

What Is a Recession, Anyway?

So, I was walking around with Jacques, and he was peeing on things, as always.  The thing was, he was peeing on lots of things that needed fixing up—fence posts that needed to be replaced, trees that needed trimming, cars with bald tires.  He looked at me all confused, and I assumed it was because he couldn't figure out why suddenly people stopped fixing their houses and replacing their bald tires.  In hindsight, I think it was just his standard confused look.

Jacques, confused

Really I think I was just projecting onto Jacques my own confusion.  When I was in 11th grade, I stumped my history teacher by asking how the great depression could have had farmers unable to sell their wheat for a reasonable price, and starving people, all at the same time.  It really is kind of a head-scratcher, and its the same problem we have now, just on a much less dramatic scale.  Somewhere on my way to an economics degree I must have picked up something though, because I can now answer the question to my 15 year old self: It's a nasty self-fulfilling loop.  Lots of people can't find jobs, or are afraid of being laid off, so they don't spend much money.  Since people are holding onto their cash, its a rough time to be a business.  So businesses lay people off, or don't hire them in the first place.  This doesn't mean that the people got laid off had the wrong skills, or that people were spending their money on the wrong things before. If this sounds pointless and stupid, it is. There's nothing morally or economically good about the fence post installer or the tree trimmer being out of work, but that's what we see all across the economy.

This is really the hardest part to understand about a bad recession like this: there is actually no legitimate reason why things should be nearly as bad as they are. This is a natural state of the economy the same way disease is a natural state of being.  Even though it occurs naturally, its something that you want to fix, and to fix it we need to understand how we got this way, why we're staying this way, and what the possible options will do.

In the meanwhile, to feel more happy and less confused, I gave Jacques a treat.

In Which I talk to Jacques About the Stimulus

So, Jacques came home from the dog park and said one of the popular dogs was telling everybody that the trillions of stimulus had failed completely. So, I told him that there are two issues here—the 8 trillion number needs to be broken into two pieces: about 800 billion in actual spending/tax cuts to stimulate the economy, and the balance in loans to banks to avoid economic disaster. While we should probably have gotten more back for our loans, they did their job by keeping banks from failing and throwing us into a large depression.

As for the 800 billion of stimulus, I said he should ask the other dog how he KNOWS that it failed? The economists using a Keynesian model said all along that the stimulus was too small, that it would pull us out of a recession, but leave the economy scraping along at about 9% unemployment, leading people to say that the stimulus failed. If they don't believe you, read what Paul Krugman said about the stimulus before it was passed, in January 2009 (the last paragraph is particularly presentient). Without the stimulus package, we'd be looking at a much worse picture, or so says the CBO. 

The especially important thing to see about the stimulus is that there were two different camps that predicted it's failure. There was the WSJ crowd, who predicted (more than 2 years ago) that sooner than later the bond market would lose faith in the US government debt, and we'd see soaring bond rates. The inflation adjusted interest rate on a 10 year Treasury is currently less than zero, the absolute rate is less that 2.2%. 

What I take that to mean is that one side predicted the outcome almost perfectly (seriously, because you might not like links, I've quoted the last paragraph of the Krugman piece below), and one side keeps talking about the bond vigilantes who never come. One side is using the economic models I learned about in Econ 101, the other side keeps talking about confidence. I'll take the models that accurately predict the market 2 years out over talk of confidence and fear of bond vigilantes that never come.  And that's what you tell the other dogs!


Krugman:

I see the following scenario: a weak stimulus plan, perhaps even weaker than what we’re talking about now, is crafted to win those extra GOP votes. The plan limits the rise in unemployment, but things are still pretty bad, with the rate peaking at something like 9 percent and coming down only slowly. And then Mitch McConnell says “See, government spending doesn’t work.”