Cause of Today's Economic Crises: Too Much Thrift
In this essay I want to propose that the ultimate of cause of today's economic crises is that we have too much thrift. This view is very similar to John Maynard Keynes' Paradox of Thrift. What I want to show is that this is not a paradox at all but confusion about what saving money really means and what consequences it has. I want to explain this confusion by way of examples and not using technical economic jargon usually used by economists. But before I can go into why too much savings leads to a disaster in the modern economy I need to clarify what I mean by savings and what money is by way of an example:
A baker produces ten loaves of bread. He consumes one loaf of bread. He barters one loaf of bread with his neighbor, the dairy farmer, for one gallon of milk. He barters three loaves of bread for one bushel of wheat with his other neighbor, the wheat farmer for wheat for next batch of loaves he will produce tomorrow. He gives one loaf of bread to the poor. He is now left with four loaves of bread. Now, he wants to be able save these loaves for his old age. So he goes to the market and sells his excess four loaves of bread for four pieces of gold. He saves the gold in his mattress. He does this because he will need loaves of bread in old age when he is physically unable to work.
Note that I am going to define pieces of gold as money for now. Because it is easier to understand. We will then expand the discussion to include fiat money. The baker saved four loaves of bread. That is his savings. Note that it is more proper to think of savings as the loaves of bread rather than the pieces of gold under his matteress. The baker is not really interested in pieces of gold but he is convinced that he can exchange them for loaves of bread when he retires. Because of this belief the pieces of gold give him psychological comfort and peace of mind that he physically owns the asset which he can exchange for loaves of bread.
Note that when he gets to his old age and goes back to the market and attempts to exchange the pieces of gold for loaves of bread he will get back loaves of bread based on the market price (in terms of pieces of gold) at the time of exchange. By acquiring pieces of gold (which is the most liquid asset in the baker's civilization) he has effectively acquired equity shares in the world economy (at least in his gold based money example economy of the baker). The market price (in terms of pieces of gold) of the loaf of bread at the future time will depend on the balance of equity shares (money) trying to purchase (bid up the price) of loaves of bread and the supply of loaves of bread at that time. Note that it is not the absolute supply of equity shares (pieces of gold) that matters what matters is the number of equity shares trying to chase (purchase) the supply of loaves of bread at that time. Another way to make the same point is this: The price of loaves of bread will not increase even if more equity shares are created and handed out unless receivers of the equity shares actually attempt to spend the newly created equity shares.
Another way our baker could have attempted to save his loaves of bread for the future is by exchanging his four pieces of gold for shares of Google stock. This gives our baker a chance to acquire even more loaves of bread if Google makes good profits in the future. Of course, the baker is taking a risk. Google may not be able to make good profits.
Now apply this situation to all excess producers participating in the world markets (by excess producers I mean people like our baker who produce more loaves of bread than they need for current consumption but would like to consume their output in the future). As people become more and more productive there is more and more excess production (if consumption does not increase in tandem with efficiency increases) then this excess production will be directed (by capital markets) to produce more and more assets which can be exchanged ultimately for consumer goods in the future. This is how we get a boom. Bust happens when excess producers realize their assets (like dot com company shares or residential and commercial real estate holdings) will not yield as much return as they expected and may even give a negative return. Rightly, excess producers then rush to safety of the most liquid asset (cash). This causes asset prices to fall and induces managers to reduce investment spending causing unemployment. But this does not mean our ability to produce goods and services has diminished.
If investment slows down and consumption does not increase production must decrease to match the new level of investment. But what usually happens during a period of reduced investment is that consumption slows down as well (unemployed and those fearing unemployment spend less) reducing demand even more and reducing production even more even though our capacity to produce has not diminished during a bust. Slow down of economic activity feeds on itself devastating the economy. In short, too much thrift devastates the economy.
On top of this productivity (output per labor hour) is continually increasing (and has rocketed upwards in the past 100 years). We will have more and more unemployment unless one of following or combination of the following occurs to a sufficient degree to stem the tide of slowdown of investment activity and improving productivity.
1. Increase investment activity. But this won't occur unless #2 below occurs.
2. Increase our consumption. Increase demand for goods and services.
3. Decrease our labor hours. Work less.
4. Do projects which will "use up" excess production.
All the stuff about too much debt (public and private) , falling asset prices and printing money is just accounting entries. We should use accounting to manage the reality around us to improve our lives and not to get confused about what is going on with the production process itself. Bad private debt should simply be liquidated. Falling asset prices does not mean that our ability to produce real goods and services is diminishing. It is in fact it is steadily increasing and has been for hundreds of years. Federal debt can be paid off with newly printed money (this is akin to converting debt to equity). Inflation will only occur if receivers of the new money actually spend it and even then if we run-up against the capacity of the world economy to deliver the demanded output.
Transfer (sale of) of treasury debt to external entities will only become a problem when the United States dollar stops acting like a global currency.
Since the dollar is (at least right now) a defacto global currency it is acting like equity shares in the economic output of the world economy. Of course, United States will not be able to maintain the position of being the sole power to issue equity shares (money) as productive capacity of other major nations increases. There are several ways to resolve this:
1. Trade less. Yes, this will slow down productivity increases. USA will build up less national debt and there will be less unemployment in the U.S. This option is not a long term resolution.
2. Share the power to issue global equity with other major nations and/or major emerging nations on some kind of a formula which everybody is comfortable with. This is a long term solution but requires a major shift in thinking.
3. United States can try to maintain USD as the only legal tender in major international transactions by force (as it does for domestic economic transactions via legal tender laws). This is not a long term solution but may be useful in the short term.
The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Also, note that possessing physical paper dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone's liability.
Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of physical paper money.
That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).
To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that's not 100% true--reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).
That difference -- that physical paper money = equity in the nation's economy, and that a bank deposit = debt (a bank obligation) causes great confusion.
We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use checking accounts for convenience (they can write checks rather than handling physical paper cash) and they don't really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank in a checking account. In fact, in most cases users of checking accounts do not want to take a credit risk. But in the current banking system there are no alternatives.
Is There a Better Way?
Consider the banking industry's contribution to society. The banking industry provides three major services to the public:
- It provides a "safe" place to hold the public's most liquid assets (cash).
- It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
- It is a source of loan money (banks evaluate the credit worthiness of borrowers). Think of "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they will end up mis-allocating economic resources.
What I am asserting is that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special "100% reserve account."
These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to "dip" into the reserves allocated to their 100% reserve accounts. Of course we would make such "dipping" illegal. The 100% accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank. The total reserves of a bank would be "safely electronically stored" at a central bank (much like reserves at the FED).
I know that Misesians and libertarians don't like central banks and are very suspicious of them. But I wanted to write this blog and start a discussion. It seems to me that electronic version of physical paper cash (i.e., digital cash) is the next natural step. Much like airline tickets are now mostly issued as e-tickets and not as negotiable paper tickets. By its nature "digital cash" would have to be stored on some central bank on a computer hard-disk (i.e, an electronic ledger) and it would also contain the owner's identifying information (i.e., the bank account number). Such "digitial cash" would NOT be debt money (as are bank deposits today) but would be "equity" money (like physical paper cash). Ofcourse we could go a step further and back-up the "digital cash" with gold reserves in the vault (but I am NOT proposing that we do this). I am trying to understand the Misesian and libertrarian distaste for a central bank. By the way I want a central bank as a safe repository of electronic money only and nothing more. I don't think a central bank should try to influence interest rates or lend money like the current FED.
Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a 100% reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the Fed).
Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion--but would not completely eliminate them.
Lending involves business risks (credit risks). If a customer were to choose a non-100% reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks' credit ratings, quality of management, etc.).
Of course, in this type of setup, a non-100% reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-100% reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don't. The accounts with credit risk would need to set their interest rates high enough to attract depositors.
If our banking system were set up this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the 100% reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.
Once this choice is given to the public, the banks can then be allowed to fail without severely impacting the payment system which is needed to conduct day-to-day commerce. The only job of the FDIC would then be to insure smooth transfer of 100% reserve accounts to another bank.
I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.