IVN News

Candidates on Both Sides Fail to See Economy’s Real Flaws

Paid Advertisement

As always, in the current  race for the presidency each of the candidates claims to have the “best” plan for the economy—without demonstrating any cognizance of our economy’s real flaws. For people on the political left, the problems most commonly cited are unemployment and poverty. People on the political right most often cite tax rates and the size of the debt public debt. Chronic instability as such (wobbling between recession and inflation) hardly ever gets mentioned, though if we are experiencing a recession or inflation each side is anxious to blame the other for it.

Of late, some people have begun adding ‘income inequality’ to the list, but I don’t think that is a problem—of economics or justice. To my mind poverty is about income relative to the cost of living, not other incomes per se. As Lester Thurow pointed out back in the early 1980’s, the best way to attack poverty would be to obviate the zero-sum problem. That is intellectually more of a challenge than taking from the rich to give to the poor is, but would presumably be more politically feasible.

Although I do agree that unemployment, poverty, tax rates, public debt, and instability are all problems that are related one way or another to the economy, not one of them is a flaw in the economy itself. Rather, they are some of the outcomes and adjuncts of a fundamentally flawed economy.

In this little essay we’ll look at the two biggest, most fundamental, worst flaws in our economic system. They are (1) making debt the source of the money the economy must have to function and (2) too much interdependence among the variables in the economy. That second flaw might seem so abstract that it is hard to see how correcting it could be of much help, but its destabilizing effects on the economy are actually more direct than the onerous effects of debt are. We’ll see how correcting those two flaws would give us the ways and means for actually putting an end to those other problems.

We must begin with money. It is the fuel of the economic engine. [For the record, I don’t mean to be pedantic, but I have no way of knowing a reader’s economic literacy.]

Money facilitates the exchanges that transpire throughout the economy. That includes the exchanges that go into producing any good or service as well as selling goods and services once they are produced.

If our economy is not growing, that is a problem. The only other possibilities are stagnation or recession. For our economy to be growing we must have a growing money supply.

Lending by individual banks is one way the money supply gets increased. That happens because banks lend out more money than they have on hand.

To say that banks are increasing the money supply when they lend out more money than they have on hand is not to say that they are printing money. Rather, loans are being made to facilitate exchanges with a total monetary value that is a multiple of the amount of money a bank has on hand.

That is done by crediting the borrower’s account with the amount of money of the loan, even though that amount of money does not actually exist. That does in fact increase the money supply, even though the amount of actual money—folding money and coins—in the bank’s vault has not changed.

To keep things straight in my own mind I think of actual money as the ‘supply of money’. The total amount of money in the economy at any time, including the money created in lending, is the ‘money supply’.

An increase in the supply of money can occur when money is lent to the central government by the central bank (in the U.S. the Federal Reserve System, the ‘Fed’). The Fed represents the banking system. So when the Fed lends money to the federal government that is the banking system as a whole providing that service.

The Fed lends money to government by buying bonds the federal government offers for sale. The Fed has the option of having the Treasury Department create money for the Fed to use to make such purchases. When that is done ‘new’ money has been created ‘out of thin air’.

Such an addition to the supply of money is still debt. Although the money is ‘printed’, gratis, by the Treasury, it must be repaid to the Fed. At the same time, creating new money that way does contribute to the possibility of a sudden onset of uncontrollable inflation.

So, when banks make loans they are adding to the money supply, but not the supply of money. When the Fed has the Treasury Department create money for it to use, that increases the supply of money—which means the money supply has increased, too. The latter subsumes the former.

The only other way the supply of money can be increased at present is through the recently invented process called ‘quantitative easing’ (QE). In QE money is created by the Treasury for the Fed to use to purchase assets from banks and other financial institutions—notably hedge funds. It adds money to the economy without involving debt.

In fact, the “assets” bought in QE are debts. Often those are debts that weren’t going to be repaid. So, QE has the salutary effect of absorbing debt—especially bad debt—from the economy.

QE was invented in 2009 to avert total economic collapse. It was invented for the purpose of adding money to the economy, but the part about not adding to debt was beside the point.

The Fed had decided that (a) more money was needed for the economy and (b) bad debt—especially the infamous ‘toxic assets’ of the time—had to be absorbed from the financial institutions holding that debt. Having the Treasury print money for it to buy those ‘assets’ accomplished both goals at once.

Quantitative easing, like any arbitrary printing of money, does come with the risk of creating an inflationary spiral that could get out of control. Though no longer being used in the U.S. at present, it is currently an active option for the central banks of the European Union and Japan.

Since we are no longer using QE in this country, just like things were before it was invented, incurring debt is the only way the economy gets supplied with the money it must have to function. That is the take-away from everything that has been written to this point in this little essay.

Lending by banks does stimulate the economy. Money is not borrowed for the purpose of having the money just sit there. A loan normally involves several thousands of dollars at a minimum, so the exchanges banks facilitate through lending are economically significant ones. Every loan, whether for a few thousands or many millions of dollars, generates an immediate increase in economic activity.

The problem is that the economic stimulation borrowing generates comes with a longer-term cost. In paying back the loan—with interest—the borrower has less money available for other economic activity. That is especially a problem with ongoing debt that never gets fully repaid.

We do have to note that if money is borrowed to start or expand a successful business, for the economy as a whole there is a net gain in future economic activity. For the sake of the fullest possible disclosure, it must be also be noted that it is possible, depending on how the money is used and what else is going on in the economy, that borrowing by government can generate a net gain in future economic activity. (Borrowing by government has a more complicated economic dynamic than private borrowing does.)

Even granting both of those exceptions, however, in the long run using debt, private or public, to stimulate the economy is inefficient and even self-defeating. That’s because debt grows faster that the economy does.

That is not abstract theory. Nor is it ideological bias. It is an historical fact. Any graph that compares total debt and GDP in the U.S. since 1980 will illustrate the point. [Gross Domestic Product is the standard measure of total economic activity in an economy.] See, for example, this graph.

Note on that graph how close total debt and the GDP were in 1980. Since World War Two they had always been close. Given all that stimulation from that huge increase in debt after 1980,the GDP has increased from then to the present at a rate above its trend between WWII and 1980, but not by very much. [Our economy became something different during that epic event than it was before that war, so WWII becomes a line of demarcation for anyone analyzing the performance of the economy.]

That increased borrowing came from both government and the private sector. Government kept increasing spending without raising taxes to pay for it. In the private sector people began using credit cards as well as their homes (through refinancing, multiple mortgages, and equity loans) to maintain, in the face of stagnating incomes, the standard of living to which middle-class people had become accustomed.

An economy with mountains of debt will not collapse unless the rate of defaulting on loans gets too high. On the other hand, we can only know after an economic collapse has occurred that the default rate got too high. When the ‘tipping point’ comes, the collapse is as sudden and swift as an avalanche. In the meantime, yet more printing of money can stave off collapse ‘for now’.

Though such an economy might not collapse, however, it will be stagnant, with very little growth overall. Only one sector of the economy will be consistently flourishing: the finance sector. That is where all the money in interest payments goes. Throw in quantitative easing, and the loveliness of life in that sector of the economy is assured. The ‘trickling down’ of money from people employed in that privileged part of the economy also helps to forestall the collapse of the whole damn thing.

Does any of that sound familiar?

The solution to the problem of using debt to supply the economy with money is perfectly straightforward. Granted, it would have to be accomplished so as to benefit the economy better than some trickle-down scheme can do. It would also have to be done without inflation. At least, though, the solution itself is perfectly obvious once using debt to supply money for the economy is correctly identified as a flaw in the system: supply money for the economy without involving debt of any kind.

The other of the two worst flaws in the economy is too much interdependence among the variables in it. “Variables” refers to the ever-changing factors in the economy that affect how it performs as a system. Those would include the total amount of the money supply, interest rates, taxes, total investment, total spending by government, total consumption by individuals and households, etc., etc.

Economists construct models. They use those models to try to predict what will happen to some variables if certain other variables change by some amount.

For example, if this or that interest rate (the ‘independent variable’) were to be changed by this amount, what affect would that have some other variable (the ‘dependent variable’), such as total investment, total consumption, etc.? In practice, of course, macroeconomic models (i.e., the economy as a whole) use many variables.

Here’s the thing: anyone who has ever constructed a macroeconomic model knows that the test of such a model is whether it tends towards equilibrium or not. If an economic model does not tend towards equilibrium that indicates that the independent variables in the model are too interdependent, i.e., too affected by changes in one another. That means that the economic system the model represents would be inherently unstable.

To avoid the problem of instability in an economic model economists include at least one independent variable in it that is ‘exogenous’. An exogenous variable is one that is unaffected any by of the other variables in the model—a truly independent independent variable. In economic modeling that can be done by ‘assuming’ values for a variable (that is to say, making up values for it) or by not allowing it to change at all, but making it a ‘constant’ for purposes of the model being constructed.

In real life, there is no such thing as a constant. Moreover, the variables in our economy are all interdependent. Everything is affected, directly or indirectly, by changes in any other thing. That makes the economy inherently unstable. It is always threatening to implode (a collapse into depression) or explode (a wild ride into hyper-inflation).

The solution to the problem of too much interdependence among the variables in our economy is as straightforward as solving the problem of using debt to supply the economy with money is: we need to create an explicitly, genuinely exogenous variable for the economy.

One might assert that variables controlled by government or the Fed are already ‘exogenous enough’ because they are not really dependent on other variables. Rather, that argument goes, the values for those variables are determined by people in authority. Whether such variables are really exogenous is in fact a never-ending debate among academic economists.

I would counter that the performance of the economy belies such an assertion. Its inherent instability indicates what economic modeling teaches us: because the economy is unstable there is too much interdependence among the variables in it. In that respect, the efforts of government and the Fed are at best expedients to prevent the worst from happening (we hope).

More particularly, the people in authority in both government and the Fed seek to ‘manage’ the economy in order to (at best) ‘maximize’ employment without causing ‘excessive’ inflation. Thus, their efforts are tied to those outcomes, which are the result of the interactions of all the variable factors in the functioning of the economy. In the end, their actions are not really independent, but are in fact determined by what is happening with the rest of the economy.

So, those are my candidates for the two worst flaws in our economic system. Having been identified, their remedies are obvious—even if how to effect those remedies is not.

One thing that does seem obvious is that it would make sense to tackle both flaws at once. We should supply the money the economy must have without using debt and make the size of the supply of money an exogenous variable.

Intuitively, it would seem that the exogenous variable should be a large variable with a significant impact on the economy. For that matter, the bigger and more significant that variable is, the better. The bigger and more significant the exogenous variable, the more it could contribute to stability. There is no bigger, more significant variable than the supply of money.

During the middle of the 1900’s Milton Friedman suggested something along these lines. His idea was to have the supply of money grow at a constant rate, theorizing that the economy as a whole would in general follow the path it set. Taking the existing supply of money and fixing its rate of growth would make it into an exogenous variable.

That notion never got much past the rumination stage. Would the money simply be printed? If so, wouldn’t that mean that over time there would be an infinitely large supply of money, and wouldn’t that at some point cause infinite inflation? Such questions never got seriously considered, much less answered, but even a hint of an idea does at least point to some of the issues that must be addressed.

Mr. Friedman’s musings also suggest another element to take into consideration. Whereas in an economic model the interactions of the variables are mechanical, in the real world the performance of the economy is the result of multitudinous decisions made by human beings. The decisions people make in the present are affected by what they think the future might hold, especially regarding big decisions such as starting or expanding a business or buying a home. In that sense, any crumb of predictability, such as Mr. Friedman’s constant rate of growth in the supply of money, would add to stability.

Yet another consideration is the neutrality of the money. The most basic definition of money is that it is ‘a medium of exchange’. The more it is that and only that, and therefore as ’neutral’ as possible, the more stable the economy will be. [That concept goes back to the early 1900’s and the very beginnings of the in economics—F.A. Hayek, Ludwig von Mises, and them, who are the titans of economics for today’s libertarians.]

That is another idea that never got very far. All of the economists who had touted it eventually renounced the idea of trying to achieve neutral money—though none of them ever denied its potential for contributing to a stable economy, if only it could be achieved. [That concept was a topic (in an appendix) in my Master’s Thesis.]

Speaking of libertarians, many of them are among those who maintain that using precious metals in the monetary system, either as currency or to ‘back’ the money, adds stability to the economy. Ultimately, the supply of precious metals certainly is exogenous. There is only so much of each of them in existence.

One problem with precious metals is that, although their total amount is fixed at any time, it is impossible to predict when more of them might be found. New, large finds would destabilize the economy.

Another problem with precious metals is that they also have other economic uses. There are markets for them that are totally separate from their possible use in the monetary system. To use them in the monetary system would get the supply of money tangled up with the markets for those metals. The money would be anything but neutral.

“Precious metals” brings to mind mining, and mining brings to mind virtual currencies, such as Bitcoins. It might have occurred to some readers that such currencies do not involve debt and seem to be exogenous.

It is true that such currencies do not involve debt, but as they currently exist they are not really exogenous. They seem to be exogenous because the total amount of (each of) them has been predetermined and will not be affected by, well, anything. In the meantime, the amount that gets ‘mined’ is random.

The thing is, though, that the value of virtual currencies is relative to each country’s legal tender, its official currency. There is an exchange rate between virtual currencies and each nation’s money. That does tie such currencies to nations’ economies, with all of their interdependent variables. It also makes such currencies less than neutral because they are objects of speculation.

[Legal tender is significant in two ways: it is the only form of payment accepted for taxes and it is the only form of repayment a lender can require of a borrower (though lender and borrower are free to work out between themselves repayment in, say, chickens and goats, if they want).]

If virtual currencies were the only currencies in existence those domestic exchange rates would not be part of the equation. In that case those currencies would be both truly exogenous and neutral.

But would they be variables? The ultimate quantity of a virtual currency is fixed. On the other hand, at any time the amount in existence is random. Furthermore, any number of such currencies could be created. That would make the total supply of money a variable.

That, however, takes us back to the connection between predictability and stability. No one would be able to say when a new supply of currency might be created. Predictability aside, if virtual currencies were our only form of money the actual advent of a new supply of currency would be destabilizing for the economy. That such an event could not be anticipated would add to its destabilizing affects.

Ultimately, this line of thought takes us to the issue of justice. Power is power, whether it is in the hands of institutions, organizations, or individuals. Power is the enemy of justice. The power to create money is a very big power, indeed. Should such power be left in the (anonymous) hands of whoever might have the capacity to wield it?

Talk of precious metals and virtual currencies as forming the supply of money does suggest that a tad more specification concerning money is necessary. Since money is, most fundamentally, a medium of exchange, almost anything can count as money in some potential exchange.

Economists have therefore developed different categories of money, based on how readily it might be used to facilitate an exchange. They designate the categories M1, M2, etc. Each category subsumes any categories that precede it and adds something new to count as money. M1 is the most basic category: the total of the currency and coins in circulation.

In my way of looking at these matters, M1 is the ‘supply of money’. M2, etc., comprise the other units of the ‘money supply’ of the economy.  Precious metals and virtual currencies have been considered here as M1

Given all that has been said to this point in this little essay, there is one other alternative to the existing monetary system that we might consider. That would be to create a new and different monetary system that would take into consideration all of the factors, elements, and issues introduced so far.

A conceptual (as opposed to mathematical) model of such a system has already been developed—by me. It would supply money for the economy without debt while at the same time making the supply of money an exogenous variable. The size of the supply of money (as M1) would be determined by demographics—and nothing else. (Banks would still make loans, but government would no longer do any borrowing.) It would feed money into the economy in such a way that its effects would be the most direct and the most certain. It does have built-in safeguards to prevent inflation. Money would be as neutral as money can be.

By the way, changing our monetary system is hardly a novel idea for this country. Counting only the times we have or have not had a central bank, we are currently on our sixth different monetary system. Also, changing the monetary system can be accomplished, as it always has been, with an Act of Congress. No diddling with the Constitution is required.

Options are provided below for further reading for anyone interested in learning more about this solution to our economy’s two worst flaws. For those intrepid souls I do have a warning.

It so happens that this particular method of fixing those flaws would eliminate (involuntary) unemployment and poverty (at no cost to anyone, without redistributing anything by obviating the zero-sum problem). It would also put an end to using taxes to fund government (which would be funded, in total—including local, state, and federal—at the current per capita rate forever as part of the operation of the monetary system).

For that matter, I have made the case that this proposal would make the economy more just. If nothing else, basing the supply of money on demographics, and only that, would mean that no individual(s), organization, or institution would have the power to influence, much less control, the size of the supply of money.

For that matter, our market-based economy would become the self-regulating thing it is supposed to be in theory. In an economy in which the supply of money and government spending are both determined by demographics and there are no taxes, there can be no means for monetary or fiscal ‘management’ of the economy.

That “warning” has been provided so that the reader won’t be put off. There is no reason for anyone to be alarmed. Economically, my proposal for an alternative monetary system is still only a solution to the two biggest, most fundamental, worst flaws in our economy as an economic system.

Further reading:

Recommended for starters: “The Secret to a Better Economy Lies in the Principles of Democracy” right here on IVN

[That title (given it by an editor) could be misleading; I like the title I gave it better: “Re-forming the Central-bank System.” The same essay appears under that title on intellectualconservative.com.

www.ajustsolution.com: for the briefest possible sketch of the actual monetary system (around 1,500 words) go there and scroll down to “A Bare-bones Sketch of the Alternative Monetary System” on the Home page. The fullest presentation of this monetary system follows that little piece of work.

“A New and Different Monetary System for a Better Economy,” also on IVN, gives a medium-sized presentation of the alternative monetary system.

Editor’s note: This article was self-published by the author, and has not been reviewed by the IVN editorial team.

Photo Credit: zefart / shutterstock.com

Join the discussion Please be relevant and respectful.

The Independent Voter Network is dedicated to providing political analysis, unfiltered news, and rational commentary in an effort to elevate the level of our public discourse.

Learn More About IVN

We've updated article comments! Our new Facebook Comments system is much faster and easier to use. Note that your old comments may not display in the new system yet, but our team is working on a solution to import old comments.