Monday, January 30, 2012

More than one way to skin a cat

In the previous post, I wanted to build a mill. I needed you farmers to give me food to feed my construction workers. The farmers and I worked out a deal where they gave me the 10 units of food I needed, and I gave them tokens worth 10 units of food. (We know that the tokens are worth that much, because I did in fact get 10 units of food in return for them.) We could say that I made an expenditure of 10 units (we don't yet have a name for this money thing).

Before that, the level of expenditure in the economy was zero. There was production and consumption--people were growing food and consuming it--but nobody was buying anything from anybody else. So my action amounted to 10 units of increased expenditure. That's the money side.

On the physical side, in response to my expenditure you farmers:
  • Increased output by a total of five units of actual food
  • Decreased consumption by a total of five units of actual food
  • Handed me a total of 10 units of actual food.
Increased expenditure of 10 has led to increased output--real economic activity--of 5.

There's a term for your decrease in consumption, which is "crowding out."  In addition to causing you to work harder, my expenditure has pushed aside some of your consumption--though note that it was an entirely voluntary action on your part: I had no way of forcing you to accept my offer that I would give you tokens in exchange for you giving me food.

What if you wanted to take my offer but didn't want to cut your consumption below 1.5?  How could you still provide me with the one unit of food that you agreed to?

You might think about increasing your production all the way to 2.5.  That way you can give me 1 unit and still have 1.5 for your own consumption.  But we assumed in the first part that the most you could produce was 2, so keeping your consumption at 1.5 by increasing production to 2.5 isn't an option.  At the same time, we also saw in the first part that the tokens I gave you are like money.  So you have another way of upholding your end of the bargain:
  • Find some other farmer--call her Jill Hill--willing to sell you half a unit of food.
  • Give Jill half your tokens.
  • Increase your production to 2.
  • Keep your consumption at 1.5.
  • Combine your "extra" half unit with the half unit you bought from Jill and hand me a whole unit, as you agreed.
Now let's assume that all 10 farmers who took my tokens do the same thing.  Each of them keeps consumption at 1.5, increases production to 2, and finds some other farmer (not one of the original 10) to buy half a unit from.  We've brought 10 new farmers into the picture, and let's assume each of them makes the same production and consumption decisions as the first 10.  They accept the half-unit worth of tokens and keep them; they increase output to 2; they keep consumption at 1.5; and they hand over half a unit of food.  Have a look at what's happened to the economy.

Instead of 10 farmers each building up savings of 1 unit, we have 20 farmers each building up savings of 0.5 units, so the total amount of savings is still 10.  But instead of 10 farmers increasing output from 1.5 to 2, we have 20 farmers doing that, so output has increased by 10, instead of by 5 as in the original example.  There's more than one way to skin a cat.

And it makes a lot of sense that the total amount of savings hasn't changed.  Remember that

==> Your ability to save is the flip side of my willingness to assume debt.

Your savings represent the ability to obtain things in the future without producing anything in the future to swap for them.  For that to be true, someone has to have made a promise to hand things over in the future without demanding anything real in exchange; someone has to have been willing to take on debt.  In this story, that "someone" is me, and since my willingness hasn't changed--I'm still borrowing to buy 10 units of food--you farmers can't acquire savings of more than 10 units in total.

But you can't have less, either.

Look at another scenario.  Each of you 10 original farmers agrees to my deal, but none of you wants to work harder, nor do you want to consume less.  "No problem," you say, "I'll just take all the tokens I received and go buy a whole unit of food from someone else."  So you go to Jill Hill and give her all your tokens.  She's just like you, Dear Reader--she doesn't feel like working harder or consuming less, so she takes the tokens from you and goes off and finds another farmer ...

Before I got my crazy idea of building a mill, everyone in our village consumed as much as they produced--there was no activity of saving.  If I'm going to be able to physically borrow 10 units of food, farmers in aggregate have to open up a gap of 10 units between what they produce and what they consume.  They have to undertake the activity of saving.  Whoever does a part of that will end up holding a part of my tokens; they will have accumulated some savings.

What if no farmers want to save?  You took tokens from me and promised one unit of food this year.  You handed the tokens along to Jill, who promised you a unit of food this year.  Jill took the tokens and handed them to Joe Schmoe, who promised her ...

Suppose Joe is the end of the line.  He's taken the tokens and promised to hand over food, but when he looks around, he can't find any other farmer willing to take the tokens and promise delivery (maybe everyone else is already somewhere in that chain of promises).  What to do?

He could knuckle down, work harder, consume less, hand over a unit of food, and keep the tokens.  He will have done 1 unit worth of saving activity, and accumulated one unit worth of savings.  Or he could go back to Jill and say, "Sorry, I can't keep my promise.  Here are the tokens."  Jill now realizes she's in a tricky spot, so she comes to you and says, "Sorry, I can't keep my promise.  Here are the tokens."  You now come to me and say the same thing.  All of the other original 10 farmers do the same.

I got all my tokens back without having to pay anything, so I don't owe anybody anything.  But I didn't get my hands on any food, either, so I can't build my mill.  Just as other people's willingness to save depends on my willingness to borrow and thus assume debt,

==> My ability to borrow depends on other people's willingness to save.

There may be more than one way to skin a cat.  But the cat has to get skinned.

Next up: A case of mistaken identity

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