Economics is the science of human action, understanding the actions man takes to achieve his goals and increase his happiness. A human being is faced with needs that he must satiate or face extinction. He survives to the extent that he does so. The same human will have desires and he thrives, or flourishes, to the extent that he satiates these. In all cases, this satiation, this consumption, requires labor so that the raw materials of nature can be changed in such a way as to satisfy him. The change can be something as simple as location, e.g., moving food from one place to another; or it can be something more drastic. Materials can be melted or frozen, combined, reshaped, improved upon. All this is in service of satisfying his needs and desires.When a man, through labor, transforms material into a state that he values more, he has increased his wealth. When he trades something he values less for something he values more, he increases his wealth, as does the other party. Wealth is subjective; another way to describe wealth is happiness, and when we realize this we see the uselessness of statistics like GDP.
His general prosperity can be increased only if he increases his capacity to produce more of the things that make him happy. There are two basic ways to do this. He can divide his labor in cooperation with others, and he can invest in capital improvements that increase his productivity.
The division of labor takes advantage of the fact that humans are a heterogeneous group with respect to their knowledge, location, proclivities, abilities and other traits. To take a simple example, if Sarah is good at making clothes and Martin is good at building houses, it behooves them to divide their labor and exchange their surpluses. Instead of Sarah having nice clothes and living in a crappy house while Martin has a decent house but crappy clothes, they may both have nice clothes and houses if Martin dedicates himself to building the houses and Sarah to making clothes. They can each make more than they personally desire in preparation for trading the surplus for the surplus the other has. They will also infuriate feminists, which will make the humble blogger wealthier.
Capital is any asset that aids in the production of other assets. A tractor, education, money, a building… all these things are capital assets. A man with a hammer can build a house more quickly than a man who has no such tool. The hammer makes him more productive, i.e., allows him to transform more material to higher valued uses in the same span of time.
It is quite clear, now, that productivity determines prosperity. Unfortunately, there are many witch doctors and charlatans who claim that the money supply must be increased to increase prosperity, or at least must go along with increased production. Without spending too much time on the subject, the good reader who has followed us thus far will no doubt have little difficulty in seeing that an increase in the supply of money does not increase productivity, it merely increases the amount of claims tickets in circulation. This will do nothing to increase actual prosperity in general, although the parties which get the increase in money first will benefit initially.
Last year, the humble blogger wrote a piece explaining money and prices, and how the latter help to regulate an economy and ration scarce resources. The good and faithful reader may wish to review this post before continuing.
Now that we understand a bit about economic activity and what wealth is, as well as money and prices, we can understand what has caused the recent recession and why Barack Obama and his band of tools and fools will only make things worse. When a central bank, like the Fed, increases the supply of credit, the interest rate will go down. The interest rate is the price of credit, and like any price it brings supply and demand into equilibrium.
A loan can be made when someone forgoes consumption that they have earned on the market, which is referred to as saving, and this foregone consumption, generally in the form of money held at a bank, can be lent out to a business interest which can use the loan to make capital investments. The market, remember, has a price structure keeping things in equilibrium. Consumers spend so much on consumption, and there is such and such supply of consumer goods to be consumed, and these forces determine market clearing prices. What is not consumed right away is saved, allowing for investment in capital goods and maintenance of the capital structure (which, we must remember, decays over time). The demand for loans and the desire to save coordinate to give us an interest rate.
When credit is artificially increased, it lowers the interest rate, and something similar to the situation detailed in the post on money occurs: people start saving less and consuming more – the lower interest rate attracts less saving – and businesses take out more loans for long term capital projects, something also induced by a lower interest rate. However, the underlying goals of the people in the economy have not changed. People have the same demand schedules as before, an interest rate change has simply changed their incentives.
The new money allows those who first get their hands on it to bid up the price of whatever it is they are investing in, and the economy starts to reshape itself around this apparent demand. Projects which before seemed unprofitable now look good with a lower interest rate. Banks lower their lending standards because they have already made the best loans available to them, and with the flood of new credit they must lend it out to less likely candidates that remain. New businesses arise around the apparent reality of the lower interest rate and the spending preferences of those who get their hands on the money.
This boom must eventually end, however, and when the money works its way through the economy, eventually the underlying reality asserts itself. Workers wages eventually go up after a period of lagging behind and this return to the old purchasing power balance means that the economy that reshaped itself around the influx of money will now go back to its original shape. Many of the new loans start to default. The projects which looked doable when the big spenders got their new money and the interest rates were low are now revealed to be mistakes and must be liquidated. This liquidation is the recession.
The process can be extended for a while, but each influx of new money makes the distortions bigger and requires more and more inflation to keep it going. Eventually, the distortion becomes so big that it either must be allowed to explode into a recession or the inflation needed to keep it going will actually destroy the currency… and the recession will be had anyway (For more on this, go to www.mises.org and search for the Austrian Business Cycle Theory).
Once this is realized, it becomes obvious that the influence of John Maynard Keynes haunts us still, and leads us down the wrong path. We are told to spend, and yet spending is for consumption. The greater the level of savings, the lower the interest rate, which means the less liquidation of investment will have to occur to get the economy back on track. Saving is the way to reduce the pain of recession, not spending! Geithner, Bernanke and Obama want to inject more credit into the economy, but this is more of what got us into trouble and will either destroy the dollar, not be enough to fend off the recession, or prevent the needed liquidations from happening, keep unsustainable businesses afloat, and prevent a return to firmer ground and a recovery.
The way out of our troubles is to let the liquidation happen and get it over with. The sooner this is done, the less painful it will be when it happens. To make things easier, the capital gains tax could be eliminated (any impediment to the accumulation of good capital restrains progress and prosperity). Any other taxes should be eliminated or at least reduced. No cheap loans to failing businesses should be made. And the more Americans save, the less liquidation has to take place.
If the humble blogger’s recommendations are followed, the recovery will happen soon and a truly stronger economy will result. I fear, however, that we are doomed to another Keynesian depression and many many years of hardship.
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