Sunday, September 25, 2011

Thesis statements in the news - and my own informative argument

You might check out Saturday's episode of Weekend All Things Considered on NPR. It is a good example of how a popular discussion of economics can easily miss what is right under its nose, solely because it lacks an adequate informative argument. One way to understand a thesis statement is as an answer to the question: "What is the reality of X"? That's a different question from "tell me what you think about X" or "what are the facts about X"? There was nothing necessarily inaccurate, factually speaking, about what they were saying on this broadcast. It is their argument, their answer to the reality question, that ends up creating a highly misleading picture.

What we need is a different informative argument, that is, a different way of framing what is important about this issue. And with that, I present to you my own brief informative argument:

At one point in the NPR broadcast, the reporter says something to the effect of "why aren't economists providing us with answers about how to get out of the crisis"? But we know from our readings that they are--it's simply that the people asking such questions don't seem actually to want to hear the answers; they just want to keep asking the question. The reporters were continually framing monetary policy in terms of affecting interest rates, but they also noted that even in normal times, this is not a very good account of how to understand what the Fed does.

Of course, you already know that the statement "economists don't really understand why using interest rates works in ordinary times" is inaccurate. Our monetarists would already argue that it works because the Fed is actually increasing NGDP, and that interest rates are a secondary effect not really worth paying attention to. Our Keynesians would argue that it works because it changes inflation. Our moderate Marxists (think Joan Robinson) would argue, in a way that is not dissimilar to the Keynesians, that it reduces the hoarding of financial assets and money, and that in turn constitutes a sign to the capitalists that they will miss out on profiting from the coming boom if they don't start investing and hiring. Our radical Marxists would argue that the real problem is the use of money, and so instead of reducing the hoarding of money, they would say we should just move to a barter economy. The last prescription is a bit absurd, but notice that in terms of its explanation of the crisis, it is actually more accurate than the standard "the Fed only has one tool--raising and lowering interest rates" type of explanation. And unlike the interest rate story, all of the other arguments actually apply to the current situation, when interest rates on safe investments are already quite low.

The problem with the interest rate story is that the Fed's real goal is to lower the price of money, not to lower the price of borrowing money (credit). The first is akin to buying a house, the second is akin to renting one--the two are different markets which have a connection to each other, but it is not hard and fast (right now, rental prices for houses and apartments are shooting up even as home prices are continuing to fall). To achieve the goal of lowering the price of money, the Fed tries to get more money into circulation. But they cannot just give it away, as they would quickly lose all control over the supply and therefore the price of money. They need a way to signal that they can withdraw the newly created money at a moment's notice if the price of money starts dropping too quickly (more on this below). So what they do is buy government bonds, in effect making a loan to a very safe borrower--the government. That means that there is almost no risk that they won't be able to sell the bonds to someone else in the future at around the same price, and thus maintain control over the supply of money.

In normal times, buying government bonds increases the supply of safe credit, which in turn lowers its price. However, the most important effect of this is to increase the supply of money in circulation and to lower its price as safe borrowers begin to borrow more and thus to spend more. In effect, people are now "selling" a lot more money, thus lowering its price. In the current situation, however, loaning money to safe borrowers like the government does not lead to a growth in the supply of money in circulation. As we see in the case of the government, they are already taking advantage of low rates by borrowing a great deal, and thus are reluctant to borrow much more. This is because the price of safe credit is already extremely low, and cannot go much lower. Crucially, it cannot go negative--although who knows if the Congress would approve new borrowing even if the rate went negative (indeed, the inflation adjusted returns on some forms of government debt is already slightly negative).  So there is already more than enough credit available for safe borrowers, and indeed those who lend out money to them are just holding on to dollars as a store of value, not as something that they could loan out to borrowers who want to spend or invest.

One part of the problem is that the bad economy makes it so that there are far fewer safe borrowers, and so a very big increase in the amount of money loaned to safe borrowers leads to a very small increase in the supply of money in circulation. This is the phenomenon of hoarding--what the Keynesians call "the liquidity trap" and monetarists call "an excess demand for money." At this point, the interest story makes even less sense, because the real problem is that safe borrowers are not spending. First of all, there are far fewer of them due to the bad economy caused by the high price of money. Secondly, those few genuine safe borrowers know that the economy is bad because of the high price of money (which is different from the price of borrowing money--credit) and so they are reluctant to take on more debt, in case the price of money starts increasing again. If they knew that the price of money would fall, they would probably reconsider their decision. However, they need to hear this directly from the government. The Fed needs to come straight out and tell everyone that they want to lower the price of money. They are not saying this. The result is that high unemployment continues, because the price of money is not dropping.

We know that a recession is actually a pretty simple process. Money is a commodity not unlike gas. Gas is a necessity for almost all market transactions. Money is a necessity for all economic transactions. If suddenly the price of both goes way up (as happened in 2008), then people will have a hard time conducting business. That will put many people out of business. A recession happens.

The hard part of understanding this simple phenomenon is to imagine a notion like "the price of money." The price of a necessary commodity like gas is easy to measure: in terms of money. But how then do we measure the "price" of money? Well, we want to measure whether it is becoming easier or harder to turn one's labor into money. Monetarists measure this using NGDP growth rates. Keynesians measure this with the concept of inflation. Moderate Marxists use the concepts of unemployment and real incomes--whether or not people can find jobs and whether they can buy more things with their salaries after deducting the costs of servicing their debts.

Now obviously, we would want the price of gas to be as low as can be. There's no limit to how low we would want it to go. The reason for this is that sudden increases in prices of necessary goods not accompanied by sudden increases in wages mean that we have fewer resources at our disposal to buy things with. Rising prices but stagnant wages = :(

The same is basically true of money, with an additional caveat. In the case of gas, big increases in price are generally bad, and big decreases are generally good. Money, however, serves a very different function, and thus changes in its price work somewhat differently. It is still generally true that prices going down is better than prices going up. However, the strange thing is that even small increases in its price are very, very bad, while small decreases are good. However, big decreases can also be pretty bad, although perhaps not as bad as big increases. The reason for this odd asymmetry can be traced back to Hobbes and social contract theory. The function of money is to bring a kind of sovereign order to economic interaction. It allows us to measure the value of goods and services, and it allows us to make contracts, such as employment contracts, using a common measure of value. But there are many instances in which we don't build inflation into a contract.

One example is a mortgage. When we take out a loan, we have to pay back a fixed amount of money over time, and this is not adjusted for inflation or deflation. If deflation occurs--if the price of money rises--then, in a sense, the home buyer now must sell his money to the bank at the original price (a home of a certain size and value) even though it is now worth more (i.e., would buy a bigger or nicer house). This may seem selfish; however, the home buyer turns around and acts in just the same fashion. Because the money the worker owes is worth more, she wants to ensure that her employer does not lower her wages. In effect, she wants to keep the employer selling her money at the cheaper price; or to put it another way, she wants to keep the employer paying more for her labor, not in fixed dollar terms, but in inflation adjusted terms. This is because informal employment contracts generally do not adjust for the price of money--for inflation. If every worker would agree to sell his or her labor for money at the original price, there would be no problem. But because the worker is being squeezed by the bank and the credit card company, she cannot do this. So in turn, the employer has to choose which employees to keep on the payroll. They have to fire some workers. One result is an increase in productivity, as suddenly one worker is doing the job of all the fired employees. This is exactly what happened during the recent slump. And this is why even small increases in the price of money, i.e. deflation, is very, very bad.

Small decreases in the price of money, however, don't have this effect. If prices in general are going up, employers can simply charge more, and use this to pay their workers more, while their debts actually stay the same--so their real (inflation adjusted) income actually goes up. If prices in general are going down, then employers have to charge less, but they cannot pay less on debts that aren't inflation indexed, and they cannot pay less to workers, because the workers in turn are stuck in the same situation, unable to renegotiate their debts. So they lay people off, which then leads to another round of the same problem. This is why slight unexpected increases in inflation have a positive effect. Most people are debtors rather than creditors, so most people experience an increase in real wages during mild inflation because their debt burdens go down as their wages or incomes go up. The only downside is that there may be a slight lag between when prices rise and when a worker or business can increase their wages or prices. But this will eventually be made up by lowering debt burdens. With deflation, not only do businesses have to lower prices, but their debt burden goes up, and to make matters worse, they have a hard time lowering their employees salaries. In general, then, as with gas or other commodities, it is good for the price of money to go down and bad for it to go up. The only exception were if the price of money were dropping so fast that we could not count on it to retain the vast majority of its value in the very short run, say within the period of a few months, a few weeks, or even in extreme cases, a few days or hours (hyperinflation). This would be bad, because people would be reluctant to accept money, and we would return to some of the inefficiencies of a barter economy. It would become harder to save and to invest, and people would start to be hurt more and more by the lag between the increase in the prices they pay and the wages they receive. As long as that lag does not present a significant risk, then inflation is running at an acceptable level.

As you can see, there is no real mystery about recessions. Economists can explain them to those who will listen. And the explanation is simple. Recessions have to do with the price of a specific asset of prime importance--money. The ideal case is for the price of money, this one very special asset that alone has the property of being necessary to conduct any economic transaction whatsoever, to be falling at a steady and predictable rate. If it increases in value, businesses may pay lower prices, but they will also have less money to pay back their debts and pay their workers. As a result, real incomes go down. On the whole more people are losing than gaining, and this is detrimental to the overall health of the economy. This leads to a pessimistic outlook, which in turn further depresses spending and therefore prices. In the case of increases in prices, employers can pass on price increases to balance out their own increasing costs while their debt burdens stay the same. As a result, real incomes go up. Thus individuals and businesses have more money, and they also do not have to pay more to service their debt, which balances out the fact that they may have to pay higher prices. On the whole, more people are gaining rather than losing, and as most feel they have a slight advantage in this situation, they feel more confident, which in turn leads to more economic activity.

In monetarist terms: recessions occur because of a fall in NGDP, which leads to falling real incomes.

In Keynesian terms: recessions occur because of deflation, which increases debt burdens and lowers real incomes.

In Marxist terms (also similar to Keynesian terms): recessions occur because the creditor class attempts to benefit at the expense of the debtor class, which harms the overall economy.

In my terms: recessions happen because people have the wrong thesis statements about economic policy.

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