Tuesday, April 30, 2013

Neither A Keynesian Nor A Classical Model


In an editorial published on April 30, 2013 under the title: “Debt and Growth” and the subtitle: “Attacking Reinhart-Rogoff to revive the spending machine,” the editors of the Wall Street Journal write about the economic model they choose to follow, saying the following about it: “In our model, every dollar of government spending has to come from somewhere, which means it is either taxed or borrowed from the private economy.”

That point is worth discussing in depth, and I'll come to it in a moment. Before I do that, however, here is what the editors of the Journal go on to say in that same paragraph: “Thus the crucial issue isn't merely the level of debt … The important matter is what that additional debt is buying.” This takes the edge off the accusation they make in the subtitle to the effect that someone out there wishes to revive the spending machine as if this – in itself – were a bad thing. Well, the Journal editors now say it may not be all that bad after all – at least under some circumstances. Fine, and I hope the apology is accepted by the other side.

This matter settled, we come back to the subject of economic model. I begin by putting down two points that no side in the debate can refute. They are these: First, the velocity of money in the system – of which the government is a part – plays a major role in the matter of growth. Second, the amount of cash in the system (called money supply) is elastic as can be seen by looking at the balance sheet of the central bank. And when a bubble is forming – in housing or the equity markets, for example – the same elasticity can be seen in the balance sheets of the private financial institutions.

Consequently, if something happens to a society that makes the private sector reluctant to invest, the money supply may remain high in the system but the velocity of money will be reduced. This will shrink the economic growth, a situation that the government can remedy by getting into the loop in a more prominent fashion thus add velocity to the money. The disadvantage of this move is that the government must get the money from somewhere. The question to ask, therefore, is where from?

Well, there was never an objection to the central bank doing “quantitative easing” which meant that the Fed printed money and exchanged it with sovereign debt, commercial papers and the like to flood the system with cash, and get the economy moving again. The idea was that the bank was merely exchanging cash, which is a form of equity, with assets which are another form of equity. This would not be inflationary, it was reasoned, because when the time will come and the economy will have started to grow, things will be returned to the way they were, thus get back to normal again.

The policy worked for a while but, like their Japanese counterparts before them, the people at the Fed discovered at some point that they had reached a saturation level after which pushing money into the system was like pushing on a string. The money sat in the vaults of the banks, the safes of big corporations as well as the wealthy but was not moving. If it did at all, it is because it had found investment opportunities abroad.

As to the local population, it chose to “deleverage” and repair its own balance sheets rather than spend the little it was earning to buy anything more than the necessities of life. This kept the local rate of growth at a low level which is why some people started to say that the government should get into the loop and help boost the velocity of the money.

This meant that the government had to borrow from a private sector that was flush with cash it was not spending, or do better than that and borrow from the central bank at near zero interest rate. The effect of this would be to put the money in the hands of people receiving entitlements or welfare or food stamps, for example. The idea being that these people would be the ones to pull on the string that the Fed could no longer push from its side. The money should gain velocity, it is thought, thus add to the growth of the economy.

Time will tell how well this model will work. In the meantime, however, it must be recognized that this is a model that neither the Keynesians nor the classicists have seen before. It is a new experiment that merits a different kind of debate not the going back to old models that no longer apply as fully as they once did.