On May 21, 2012 the Wall Street Journal took up the debate now raging in
the American presidential campaign. It is about the role that financiers play
in the economy, and the instruments they use to conduct their business. To
articulate its position on the subject, the Journal wrote an editorial under
the title: “Bain Capitalism 101” and the subtitle: “How does a rapacious
company get repeat business?” The editorial defends the activities of Bain
Capital (once run by one of the candidates) against the charges that it
“...buys a company, loads it with debt and then sucks out cash before foisting
the wounded business upon an unsuspecting buyer or a bankruptcy court.” The
editors of the Journal argue that this could only be true if the critics assume
that “the financial industry is full of saps,” but these same critics also
describe the financiers as being “greedy schemers,” say the editors. And so
they conclude: “...financiers can't be both knaves and diabolical geniuses at
the same time.”
This is an argument based on reason that puts the subject inside a neat
little frame. But things are not always this reasonable or this simple. The
fact is that markets are driven by fear and greed. At any given time, the same
person could be motivated by one sentiment or the other or even both sentiments
at the same time. And it often happens that people make money one day then lose
it the next day not because they thought things through before choosing a
course of action but because they let their emotions dominate the process of
making a choice. Thus, it can be said that the engine which powers the markets
is not that of knave versus genius; it is that of greed versus fear. But
this is not what the debate ought to be about. Instead, the debaters should
focus on the search for a solution to the current problem of anemic growth. And
when they find it, they should advocate it regardless as to who may be
embarrassed in the process.
Given that the situation has aspects never experienced before,
we need to go back to the fundamentals and start our probe there. Since the
business cycle has not yet been repealed, it happens that an economy can go
into a period of slowdown thus cause vexing problems, chief among them
unemployment. If the situation persists, the central bank and the treasury will
be inclined to intervene so as to nudge the economy into moving again; and they
have the means to do so. The central bank has monetary tools such as the
authority to set the interest rates and to print money. The treasury of the
government has the authority to tax, to borrow and to spend. The aim of both
institutions is to regulate the money supply which, in turn, is supposed to
regulate something called the velocity of money.
What is that? Good question. Perhaps the best way to explain
it is to take an example. You and I are friends; we graduated from school not
long ago and had some work experience. We each have an idea for a venture; we
each want to go into business but neither of us has money. In the meantime,
your uncle who is till young has been working for a time and has saved some
money. He too wants to go into business and he knows exactly what he wants. He
has an eye on the hardware store that is up for sale around the corner from his
house. The owner of the store is asking 100,000 dollars but your uncle has put
together only 75,000 dollars. He says he will borrow the balance from the bank
and pay it back from the profit that the business will generate.
What a great idea, I say to you; this will give us the
opportunity to launch our own businesses. No we can't, you say, because neither
of us has any money and the bank will not lend us 100% of the capital we need
to start the businesses. True, I say but it is customary in such cases that
people borrow seed money from friends and family then approach the bank for a
loan. Yes, you say but the friends and families of both of us have already done
that. In fact, this is how the uncle was able to put together the 75,000
dollars. Yes, I retort, and this is precisely the point I am making.
Puzzled, you ask: How is that? I explain that the hardware
store will generate a cash flow. The uncle can either pay back the loans at an
accelerated rate or he can pay only what is due each month, and lend to you the
surplus. With this seed money, you start your business on a modest scale and
grow it a little at a time using the cash it will generate and the cash you
will continue to receive from your uncle. When your business will start to
generate a surplus, you will begin to lend to me and I launch my business.
Thus, we see that a flow of cash will be moving from your uncle to you and then
to me at a rate we call the velocity of money.
But who has the power to affect or determine the velocity of
money in the grand scheme of an economy? This too is a good question but it is
more complicated to answer. In normal times, the central bank and the treasury
have this power but things do not always work out that way especially when
times are not normal. The principle involved here is that when money is pumped
into the economy, and if it is made cheap enough to borrow, the businesses and
the general public will borrow and spend. Depending on how much of it is pumped
and how cheap it is made to borrow, the money will exchange hands at a
corresponding rate which means it will move at a commensurate velocity.
But there comes a time when the psychology of the business
owners and/or the public plays a major role in determining the velocity of
money despite the measures taken by the central bank and the government. This
happens when something serious hits the economy, and the people lose confidence
in the system that underlies it. Fearful of what tomorrow may bring, the people
tend to hold on to their money instead of spending it. No matter how much of it
the central bank and the treasury pump into the economy, and no matter how
cheap it is to borrow, the people will hoard the money and wait for better days
before spending it. The Japanese were the first to experience this phenomenon, and
they described the act of pumping money into the economy under these conditions
as being like pushing on a string.
Oddly enough, this is where a possible solution to the
problem can be found. Why not pull at the far end of the string rather than
push on it at the near end? I began to think about this approach because I
could see the resemblance between electronic circuitry and a theory I had
developed a while ago calling it the circuitry of economics. And then it
happened that something like it was tried and proven successful but only
partially. It is that a stimulus package was put together whereby potential
buyers were offered a rebate if they traded their old car for a new one. The
plan worked while it was in force but stopped when the incentive money dried
up. In addition, the sale of cars in the immediate future dropped because the
people who would have bought a car then had already satisfied their need for
one. Thus, I concluded that this one-time operation cannot be a substitute for
refurbishing the economic circuitry. What is needed is a more comprehensive
overhaul.
To do that, we need to understand that the problem plaguing
the economy at this time can be described with one sentence: it is exhibiting
poor response to stimulus. Well, the same sort of problem exists in electronics
and there are remedies for it. Can these remedies be applied to the economy? It
looks to me like the answer is yes. To see how this may work, we need to know
that there are three types of current. The two most familiar to people are the
Direct Current (DC) and the Alternating Current (AC). But there is also the
pulsating current which happens to play an important role in digital circuits.
The first thing we need to know is that DC cannot carry information;
therefore it is not used for communication. What is needed is an alternating
current or a pulsating one because they can be in one of two states: ON or OFF.
Having this characteristic, they are used in the form of a code to carry a
message; be it a Morse code, a human voice, a picture or what have you. And
when something goes on and off, the speed at which it does so is called the
frequency. This is what determines the velocity at which the message moves
through hardware. Thus, the frequency response of a circuit becomes one of its
most important features. And the same can be said about an economic circuit
where a speedy response to stimulus is the goal. I must, at this point, caution
the reader that a message moving in hardware must not be confused with the
electromagnetic wave whose velocity in the ether remains the constant speed of
light at any frequency.
The importance of seeing that the message is a part of the
economic circuitry becomes apparent when we consider that the psychology of
people plays a role in determining their propensity to hoard money or to spend
it. And this says that in the same way we design an electronic circuit to make
it respond better to a higher frequency, we can make an economic circuit
respond better to a financial stimulus. In modern electronics, a stand alone
transistor or a number of them integrated into a chip act as switches. They go
from the ON position to the OFF position or the other way around by charging
and discharging a small amount of electricity. How fast this is done depends on
the quality of the components and the design of the circuit. But this is what
determines the frequency response of the circuit.
But if you are a designer of circuits, and you are
constrained by the components you must use as well as the design that suits the
application, can you do something that will make the circuit respond faster
than normal? The answer is yes. To see how this is done, you need to know that
the discharge of a pulsating current normally goes to a neutral ground which
acts like the drain of your sink. To make the discharge go faster, you can
attach to the system a pump that will suck that discharge. In electronics, this
is done by having the discharge go not to a neutral ground but to a negative
terminal. This is why some circuits have a negative terminal in addition to the
positive terminal and the neutral ground.
The transistor switches take time to charge and discharge
because they have an internal capacitance even though they are not capacitors.
This property being what allows them to operate the way they do, what is there
in economics that equates with the electronic capacitor? The answer to this
question is made complicated by the fact that it is twofold. There is the
storeroom and there is the wallet/bank account. The first is an area with the
capacity to hold goods for a time before shipping them out. The second is a
place where money is stashed and taken from. There was a time when the Japanese
had attempted to make use of the storeroom capacitance to force their economic
circuitry to operate at a higher frequency. But the idea backfired because it
was the wrong thing to do at the wrong time. They called the operation a “just
in time” approach to doing business. For example, an assembler of appliances
would order the parts that he needs just in time before using them. He thus
shortened the time during which he stored them and thus saved money.
That approach failed because it distorted the message as it
rippled through the economic circuitry. It did so in two ways. First, it caused
the volume and velocity of money to increase so as to keep up with the payment
of bills in the just-in-time environment. Second, the approach conveyed to the
public the notion that the goods they produce and consume have a value stored
in them that is no better than the trash they dispose of. The idea then spread
to the services and caused the same problems there. The result has been that
the magnitude and complexity of the distortion forced the people to look for
something they can think of as having a more durable value stored in them. They
turned to real estate and to art objects where bubbles formed and brought down
the whole economic system.
In a nutshell, what happened that started the ball rolling
was that the message was distorted. When something like this happens, the
psychology of human beings is such that they distrust and reject every message
that comes their way without bothering to check whether it is a valid message
or a fake one. They curtail their activities and wait for the situation to clarify
itself. Thus, the question to ask is: How to change all that?
The first thing we do is state what the goal is. It is to
have a source of money and a circuit in which it can move unimpeded by bad
psychology or otherwise. When things go normally, the money will drain itself
and no extraordinary action is needed. When things start to go badly, the
demand for money slows, and this compels the central bank and the treasury to
act as sources of last resort to stimulate the economy. But things can get
worse still, and no matter how much the bank and the treasury try to stimulate
the economy, the circuit remains blocked because it is like pushing on a
string. In this case, the government and the treasury must act as pump to suck
the money at the other end of that string. In fact, right now the bank believes
it can do so by manipulating the short term versus long term curve of interest
rates. But the method has proven to be largely ineffective.
What is needed is a comprehensive approach not a half
measure. In fact, the appropriate question has only now been asked: How to
stimulate the economy and have austerity at the same time? To properly answer
this question, we must deal with three areas. They are the source, the bulk of
the circuit and the drain. At the source, you maintain the money cheap and
plentiful. At the drain you lower the taxes on profit realized from operations
but you raise them on capital, especially the large dormant bank accounts. Mind
blowing but it must be done – preferably by all nations at the same time.
As to the bulk of the circuit, you help create bypasses by
encouraging second tier financial institutions to grow and take business away
from the “too big too fail” so that they understand they are too big to be left
unbroken. Either they break themselves or the law will compel them to do it.