Monday, March 12, 2012

A case of mistaken identity

(This is the third in a series of posts about money.  Here are links to the first and the second posts.)

Looking for the most contentious issue in political discussions of economics today?  Here's a candidate:

Can government spending lead to an overall increase in economic activity and employment?

It's something of an embarrassment to the field of economics that this is such a question.  I'm trying to think of the right analogy--maybe this one works:

In this post I’m only going to half-answer the question, because our mill parable is still a kind of free-market paradise, unsullied by the tawdry doings of government. But even so, we have some tools to start understanding what role a government might play. I’ll come back to a more careful treatment of government in a later post.

There’s a common-sense observation behind the claim that government can’t play any useful role in increasing employment or output. The obvious point is that, “The money has to come from somewhere.” So if the government does more, others must be doing less, and the net effect has to be roughly zero. And though we don’t yet have a government in the model, we can already look at a situation where a related phenomenon trips people up: the gripping subject known as the “investment-savings identity.”

Identifying an identity
Economics makes use of a number of accounting identities, things that resemble equations, but function differently.

An equation might be something like:

2 + x = 5.

The variable x doesn't have any prior definition, so it could, in principle, take on any value. Which means the equation could be true or false. It's true when x is 3. The point of the equation is to find the set of values of x that make it true (in some equations there’s more than one).

An accounting identity is a different beast—it's something that must be true, because of the way its parts are defined. An example would be:

(Your total income) – (Your tax bill) º (Your after-tax income)

The definition of your after-tax income is simply your total income, minus your tax bill. If you know any two of those numbers, you know the third one, by definition.

The guilty party
As hinted above, one of the standard identities in economics is:

Investment º Saving.

In other words, the amount of investment activity cannot be different from the amount of saving activity.

The previous twist on the mill parable certainly supported that idea (though it doesn't prove it—after all, this is just a parable). In that version of the story, there were lots of different ways to arrange it so that my investment activity equaled the total savings activity of all you farmers. It didn't matter who passed along how many of my tokens, who grew how much food and who ate how much, as long as, in total, 10 units of food were saved out of production and made available to me. If you farmers didn't save—if you didn't consume less than produced—I couldn't undertake my investment.

So the problem is not that the investment-savings identity is false—logic (assisted by the parable) suggests that it’s true. The problem is the temptation to borrow too much from our individual experience when we use the identity.

Sequential thinking
Say I want to open a small store—I want to make an investment. Where can I get the money to do it? My start-up costs are bigger than my income (or at least bigger than what's left of my income after taxes and basic living expenses), so I can't just save right now by cutting back my spending and using the unspent income to start my business. If I'm going to do this without borrowing, I have to save up ahead of time. I figure out that if I manage to put away 30% of my income for 5 years, I'll have enough money in the bank to get things going. Things have to go in sequence:

First save, then invest.

Of course, I could borrow. I could find someone willing to lend me the start-up costs, which would mean I could invest without first having saved. But that would mean that someone else had savings that could be made available to me. If those savings don't exist somewhere in the economy, I can't invest. So we modify the previous statement about the sequence of events:

First (someone) saves, then (someone else) invests.

There are two problems with this sequential view of saving and investment. The first is that it confuses a quantity of savings—money or bonds or stocks stored away for later use—with the activity of saving. The second is the implicit assumption that the quantity of saving activity is fixed.

Money as a means
Go back to the mill parable. Money itself wasn’t the important thing. What I needed was access to food for the workers who were going to be building my mill. I could have had $100 million, and it would have been irrelevant if people hadn’t been willing to sell me food. And if farmers were going to sell me food, they were going to have to consume less than they produced—they were going to have to engage in the activity of saving. In other words, my $100 million, my quantity of savings, would only be useful if it convinced people to engage in the activity of saving.

Conversely, if I can somehow convince the farmers to give me food, to undertake the activity of saving, then I can do my investment, regardless of how little a quantity of savings I may have socked away. The investment-savings identity introduced above is not fundamentally about money. It usually gets expressed in money, but underneath, it's an identity between investment activity and the activity of saving, the act of consuming some amount less than current output.

Flexible saving
And the level of saving activity is not fixed—it can change in response to people’s willingness to borrow, their willingness to undertake real investment. The mill parable started with no savings stored up, and no saving activity; everything produced was consumed. What made my mill project possible was not that 10 or 20 farmers suddenly thought, “I’d like to consume less than I produce this year, in exchange for the ability to consume more than I produce in future years. I wonder if that nice fellow over by the creek would like to promise us food in the future in exchange for food in the present so that he can build a mill.” It went completely the other way. I conceived the notion of the mill, and the farmers responded. It’s true that I depended on their willingness to accept my offer, or else I would have been up a creek, not just next to one. But it was my desire to create the mill that not only provided them with their tokens (their quantity of savings), but called into being their physical activity of saving.

The investment-savings identity must hold, but not because investment is limited by the quantity of saving that people have already decided to engage in. Investment is only limited by the quantity of saving activity that people can be induced to choose.

What’s more, without the borrower, your saving activity would be pointless. I said in the last post that, “Your ability to save is the flip side of my willingness to acquire debt.” That is, your ability to acquire claims on future output depends on my willingness to give you those claims. But then, without the ability to acquire claims on future output, without the ability to accumulate a quantity of savings, why would you bother to engage in saving activity? Why consume less than you produce today, if it won’t lead to any future benefit?

So can government spending lead to an overall increase in economic activity and employment?  Without a government in the model, we can't really answer that.  But we can address the most common objection, the idea that "the money has to come from somewhere," so that any increased spending by the government must be offset by decreasing spending somewhere else.

It's true that money has to come from somewhere, but one of the places it can come from is thin air.  We'll see later whether government can pull off this same trick.

Doing saving vs. having savings
One last macabre twist on the story to sharpen the distinction between saving activity and accumulations of money.

Suppose you accept my offer. You take my tokens, you give me the food I need for my workers, and you look forward to enjoying the benefits of your thrift. The mill gets built, the food is all used up and then—Calamity! A spring flood sweeps away the mill, and me with it. Your savings are destroyed: you still have my tokens, of course, but they’re worthless, because everybody knows I’m not in a position to honor them. In contrast, your saving activity is unaffected. It was entirely in the past, and it was balanced by my investment activity, even if there’s no longer any more trace of my mill than there is of your money savings.

Next time: Bring on the state!

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