ECONOMIC RECOVERY REQUIRES CAPITAL ACCUMULATION NOT GOVERNMENT “STIMULUS PACKAGES”

This two-part article is the second in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity. The first article in the series was “Falling Prices Are Not Deflation but the Antidote to Deflation.”

Part I: Capital, Saving, and Our Economic Crisis

Imagine an individual who is lethargic and lacks the energy to function at his normal level because of too little sleep. There are drugs that can make him feel fully refreshed, even after a night without any sleep whatever, and apparently capable of functioning the next day with full efficiency.

Nevertheless taking such drugs is definitely not a good idea. This is because the individual’s underlying problem of insufficient sleep is not only not addressed by his being stimulated but is actually worsened. For the stimulus further depletes his body’s already diminished energy reserves and takes him down the path of utter exhaustion.

This description applies to the current slowdown in our economic system and to the efforts to overcome it through the use of “fiscal policy” and its “stimulus packages.” The meaning of these terms is more government spending and lower taxes specifically designed to promote consumption. This includes giving income-tax refunds to people who paid no income tax and who, because of their low incomes, can presumably be most counted on to rush out and consume more as soon as additional funds are put in their hands.

The main difference between such economic “stimulants” and pharmaceutical stimulants is that the economic stimulants will not succeed even in temporarily restoring the economic system to anything approaching its normal level of activity.

An economic system entering into a major recession or depression is in a situation very similar to that of our imaginary, sleep-deprived individual. All that one need do is substitute for the loss of the sleep required for the body’s proper functioning the loss of something required for the proper functioning of the economic system.

Capital

In the case of the economic system, that something is capital. The economic system is not functioning properly because it has lost capital. Capital is the accumulated wealth that is owned by business enterprises or individuals and that is used for the purpose of earning profit or interest.

Capital embraces all of the farms, factories, mines, machinery and all other equipment, means of transportation and communication, warehouses, shops, office buildings, rental housing, and inventories of materials, components, supplies, semi-manufactures, and finished goods that are owned by business firms.

Capital also embraces the money that is owned by business firms, though money is in a special category. In addition, it embraces funds that have been lent to consumers at interest, for the purpose of buying consumers’ goods such as houses, automobiles, appliances, and anything else that is too expensive to be paid for out of the income earned in one pay period and for which the purchaser himself does not have sufficient savings.

The amount of capital in an economic system determines its ability to produce goods and services and to employ labor, and also to purchase consumers’ goods on credit. The greater the capital, the greater the ability to do all of these things; the less the capital, the less the ability to do any of these things.

Saving

Capital is accumulated on a foundation of saving. Saving is the act of abstaining from consuming funds that have been earned in the sale of goods or services.

Saving does not mean not spending. It does not mean hoarding. It means not spending for purposes of consumption. Abstaining from spending for consumption makes possible equivalent spending for production. Whoever saves is in a position to that extent to buy capital goods and pay wages to workers, to lend funds for the purchase of expensive consumers’ goods, or to lend funds to others who will use them for any of these purposes.

It is necessary to stress these facts because of the prevailing state of utter ignorance on the subject. Such ignorance is typified by a casual statement made in a recent New York Times news article. The statement was offered in the conviction that its truth was so well established as to be non-controversial. It claimed that “A dollar saved does not circulate through the economy and higher savings rates translate into fewer sales and lower revenue for struggling businesses.” (Jack Healy, “Consumers Are Saving More and Spending Less,” February 3, 2009, p. B3.)

The writer of the article apparently believes that houses and other expensive consumers’ goods are purchased out of the earnings of a single week or month, which is the normal range of time between paychecks. If that were the case, no savings would be necessary in order to purchase them. In fact, of course, the purchase of a house typically requires a sum equal to the purchaser’s entire income of three years or more; that of an automobile, the income of several months; and that of countless other goods, too large a fraction of the income of just one pay period to be affordable out of such limited funds.

In all such cases, a process of saving is essential for the purchase of consumers’ goods. The savings accumulated may be those of the purchaser himself, or they may be borrowed, or be partly the purchaser’s own and partly borrowed. But, in every case, savings are essential for the purchase of expensive consumers’ goods.

The Times reporter, and all of his colleagues, and the professors who supposedly educated him and his colleagues, all of whom spout such nonsense about saving, also do not know other, even more important facts abut saving. They do not know that saving is the precondition of retailers being able to buy goods from wholesalers, of wholesalers being able to buy goods from manufacturers, of manufacturers, and all other producers, being able to buy goods from their suppliers, and so on and on. It is also the precondition of sellers at any and all stages being able to pay wages.

Such expenditures must generally be made and paid for prior to the purchaser’s receipt of money from the sale of his own goods that will ultimately result. For example, automobile and steel companies cannot pay their workers and suppliers out of the receipts from the sale of the automobiles that will eventually come in as the result of using the labor and capital goods purchased. And even in the cases in which the payments to suppliers are made out of receipts from the sale of the resulting goods, the seller must abstain from consuming those funds, i.e., he must save them and use them to pay for the capital goods and labor he previously purchased.

In contrast, the Keynesian reporters and professors believe that sellers do nothing but consume or hoard cash. They are too dull to realize that if that were really the case, there would be no demand for anything but consumers’ goods. This becomes clear simply by following the pattern of the Keynesian textbooks in allegedly describing the process of spending.

Thus a consumer buys, say, $100 dollars worth of shirts in a department store; the owner of the department store, following his Keynesian “marginal propensity to consume” of .75, then buys $75 worth of food in a restaurant, and allegedly hoards the other $25 of his income; the owner of the restaurant then buys $56.25 (.75 x $75) worth of books, while allegedly hoarding the remaining $18.75 of his income; and so on and on. Now, unknown to the Keynesians, if such a sequence of spending actually took place, all that would exist is a sum of consumption expenditures and nothing else.

The fact is that most spending in the economic system rests on a foundation of saving. The seller of the shirts will likely save and productively expend $95 or more in buying replacement shirts and in paying his employees and making other purchases necessary for the conduct of his business, and perhaps only $5 on consumption. And so it will be for those who sell to him, or to the suppliers of his suppliers, or to the suppliers of those suppliers, and so on.

Any business income statement can provide a simple confirmation of such facts. The ratio of costs to sales revenues that can be derived from it, is an indicator of the ratio of the use of savings to make expenditures for labor and capital goods relative to sales revenues. For the costs it shows are a reflection of expenditures for labor and capital goods made in the past. The saving and productive expenditure out of current sales revenues will show up as costs in the future. The higher is the ratio of costs to sales, the higher is the degree of saving and productive expenditure relative to sales revenues. A firm with costs of $95 and sales revenues of $100 is a firm that can be understood as saving and productively expending $95 out of its $100 of sales revenues. This relationship applies throughout the economic system.


Hoarding Versus Saving

To the extent that “hoarding” or, more accurately, an increase in the demand for money for cash holding takes place, it is not because people have decided to save. What is actually going on is that business firms and investors have decided that they need to change the composition of their already accumulated savings in favor of holding more cash and less of other assets.

For example, an individual may decide that instead of being 90 percent invested in stocks and other securities and having only 10 percent of his savings in cash in his checking account, he needs to increase his cash holding to 20 or 25 percent of his savings.

Similarly, a corporation may decide that it needs to increase its cash holding relative to its other assets in order to be better able to meet its bills coming due. Indeed, this is happening right now as more and more firms find that they can no longer count on being able to borrow money for such purposes.

Furthermore, the increases in cash holdings that take place in such circumstances are not only not an addition to savings but occur in the midst of a sharp decline in the overall amount of accumulated savings. For example, the increases in cash holdings that are taking place today are in response to a major plunge in the real estate and stock markets, of numerous and sizable corporate bankruptcies, and of huge losses on the part of banks and other financial institutions.

All of this represents a reduction in asset values, i.e., in the value of accumulated savings. People are turning to cash in order to avoid further such losses of their accumulated savings. Of course, widespread attempts to convert assets other than cash into cash, entail further declines in the value of accumulated savings, since the unloading of those assets reduces their value.

Accumulated savings in the economic system have fallen by several trillion dollars, and nothing could be more incredible than that, in the midst of this, many people, including the great majority of professional economists, fear saving and think that it is necessary to stimulate consumption at the expense of saving. Such is the complete and utter lack of economic understanding that prevails.

One might expect that a group of people such as most of today’s economists, who pride themselves on their empiricism, would once and a while look at the actual facts of the world in which they live, and, in the midst of the loss of trillions of dollars of accumulated savings, begin to suspect that there might actually be a need to replace savings that have been lost rather than do everything possible to prevent their replacement.

Depressions and Credit Expansion

The loss of accumulated savings is at the core of the problem of economic depressions. Recessions and depressions and the losses that accompany them are the result of the attempt to create capital on a foundation of credit expansion rather than saving. Credit expansion is the lending out of new and additional money that is created out of thin air by the banking system, which acts with the encouragement and support of the government. The money so created and lent has the appearance of being new and additional capital, but it is not.

The fact of its appearing to be new and additional capital creates an exaggerated, false understanding of the amount of capital that is available to support economic activity. Like an individual who believes he has grown rich in the course of a financial bubble, and who is led to adopt a level of living that is beyond his actual means, business firms are led to undertake ventures that are beyond their actual means.

For an individual consumer, the purchase of an expensive home or automobile in the delusion that he is rich later on turns out to be a major loss in the light of the fact that he cannot actually afford these things and would have been better off had he not bought them. In the same way, business construction projects, stepped up store openings, acquisitions of other firms, and the like, carried out in the delusion of a sudden abundance of available capital, turn out to be sources of major losses when the delusion of additional capital evaporates.

Credit expansion also fosters an artificial reduction in the demand for money for cash holding, which sets the stage for a later rise in the demand for money for cash holding, such as was described a few paragraphs ago. The reduction in the demand for money for cash holding occurs because so long as credit expansion continues, it is possible for business firms to borrow easily and profitably and thus to come to believe that they can substitute their ability to borrow for the holding of actual cash. The rising sales revenues created by the expenditure of the new and additional money that is lent out also encourages the holding of additional inventories as a substitute for the holding of cash, in the conviction that the inventories can be liquidated easily and profitably.

Recessions and depressions are the result of the loss of capital in the malinvestments and overconsumption that credit expansion causes. The losses are then compounded by the rise in the demand for money for cash holding that subsequently follows. They can be further compounded by reductions in the quantity of money as well, such as would occur if the losses suffered by banks resulted in losses to the banks’ checking depositors. (Checking deposits are part of the money supply, indeed, the far greater part. In such cases, they would lose the status of money and assume that of a security in default, which would render them useless for making purchases or paying bills.)

The Housing Bubble

Our housing bubble is an excellent illustration of the malinvestment and overconsumption caused by credit expansion. Perhaps as much as $2 trillion or more of capital has been lost in the construction and financing of houses for people who, it turned out, could not afford to pay for them. The housing bubble was financed by the creation of $1.5 trillion of new and additional money in the form of checking deposits created for the benefit of home buyers.

The creation of these deposits rested on the readiness of the Federal Reserve System to create whatever new and additional supporting funds were required in the form of bank reserves. In the three years 2001-2004, the Federal Reserve created enough such funds to drive the interest rate paid on them, i.e., the Federal Funds Rate, below 2 percent. And from July of 2003 to June of 2004, it created enough such funds to hold this rate down to just 1 percent. The end result was a substantial reduction in mortgage interest rates and thus in monthly mortgage payments, which served greatly to increase the demand for houses.

Government also greatly contributed specifically to loans being made to homebuyers who were not credit worthy. It did this through its various loan-guarantee programs, carried out by Fannie Mae, Freddie Mac, and the Department of Housing and Urban Development; and by means even of outright extortion, though the Community Reinvestment Act, which required banks to make sufficient such loans as would satisfy local “community groups.”

In physical terms, the result of credit expansion was the passage of literally millions of houses that represented capital to the firms that built them, and to the banks and others that financed them, into the hands of consumers who not only had not contributed anything remotely comparable to the wealth and capital of the economic system but also had no realistic prospect of ever being able to do so. The further result has been that many of the builders of these houses are now ruined as are many of the banks and other investors that financed the construction and sale of those houses. And because so many lenders have lost so much, the business firms that depend on them for loans can no longer obtain those loans, and so they must close their doors and fire their workers.

The growing problem of unemployment that we are experiencing and the accompanying reduction in consumer spending on the part both of the unemployed and of those who fear becoming unemployed is the result of this loss of capital, not of any sudden, capricious refusal of consumers to spend or of banks to lend. Indeed, the kind of consumer spending that so many people want to revive and encourage, by means of “stimulus packages,” played a major role in the loss of capital that has taken place and now results in unemployment and impoverishment.

During the housing boom, millions of owners of existing houses thought that they were growing rich as the result of the rise in the prices of their homes and that they could actually live to a substantial degree off the accompanying increase in the equity in their homes. They borrowed against the increased equity and spent the proceeds. This consumption was at the expense of capital investment in the economic system, which was rendered correspondingly poorer by it. And when housing prices collapsed, and fell below the enlarged mortgage debts that had been taken on, the effect was to add to the losses suffered by lenders. This was the case to the extent such equity-consuming homeowners then walked away from their homes, leaving their creditors to lose by the decline in the price of their homes.

Keynesian Ignorance and Blindness

The immense majority of people, including, of course, most professional economists, are ignorant of the actual nature and cause of our financial crisis. This is because they are ignorant of the role of capital in the economic system. They are all Keynesians. (Even Milton Friedman, the alleged arch-defender of capitalism is reported to have said, “We are all Keynesians now.”)

But as von Mises so aptly put it, “The essence of Keynesianism is its complete failure to conceive the role that saving and capital accumulation play in the improvement of economic conditions.” (Planning for Freedom, 4th ed., p. 207. Italics in original.) In the eyes of Keynes and his countless followers, economic activity begins and ends with consumption.

So deeply do people hold the view that consumption is everything, that it blinds them to obvious facts. Thus, the present crisis has been well underway at least since the late spring of 2007, when the sudden collapse of two large Bear Stearns hedge funds occurred. This was followed by a continuing string of bankruptcies between June of 2007 and August of 2008 of significant-sized and fairly well-known firms, such as Aloha Airlines, Levitz Furniture, Wickes Furniture, Mervyns Department Stores, Linens N’ Things, IndyMac Bank, and Bear Stearns itself. The list includes an actual run on a major bank—Northern Rock in Great Britain—in September of 2007, probably the first such run since the 1930s.

Financial failures reached a crisis point in September of 2008, with the collapse of such major firms as American International Group (AIG), Lehman Brothers, and the Halifax Bank of Scotland. These were followed by the bankruptcy of Fannie Mae and Freddie Mac, the two giant government-sponsored mortgage lenders that had led the way in guaranteeing sub-prime mortgages to borrowers who could not repay them.

Yet as late as September of 2008, the unemployment rate in the United States was no more than 6.2 percent and at mid-month the Dow Jones Industrial Average was still well above 11,000.

All this confirms that the crisis did not originate in any sudden refusal of consumers to consume or in any surge in unemployment. To the extent that unemployment is growing and consumption is declining, they are both the consequence of the economy’s loss of capital. The loss of capital is what precipitated a reduction in the availability of credit and a widening wave of bankruptcies, which in turn has resulted in growing unemployment and a decline in the ability and willingness of people to consume. The collapse in home prices and the more recent collapse in the stock market have also contributed to the decline in consumption, and probably to an even greater extent, at least up to now. Both of these events are also an aspect of the loss of capital and accumulated savings.

What Economic Recovery Requires

What all of the preceding discussion implies is that economic recovery requires that the economic system rebuild its stock of capital and that to be able to do so, it needs to engage in greater saving relative to consumption. This is what will help to restore the supply of credit and thus help put an end to financial failures based on a lack of credit.

Recovery also requires the freedom of wage rates and prices to fall, so that the presently reduced supply of capital and credit becomes capable of supporting a larger volume of employment and production, as I explained in “Falling Prices Are Not Deflation but the Antidote to Deflation,” which was my first article in this series. Recovery will be achieved by the combination of more saving, capital, and credit along with lower wage rates, costs, and prices.

In addition, recovery requires the rapid liquidation of unsound investments. If borrowers are unable to meet their contractual obligation to pay principal and interest, the assets involved need to be sold off and the proceeds turned over to the lenders as quickly as possible, in order to put an end to further losses and thus salvage as much capital from the debacle as possible.

In the present situation of widespread financial paralysis, firms and individuals can be driven into bankruptcy because they are unable to collect the sums due them from their debtors. Thus, for example, the failure of mortgage lenders would be alleviated, if not perhaps altogether avoided in some cases, if the mortgage borrowers who were in default on their properties lost their houses quickly, with the proceeds quickly being turned over to the lenders.

In that way, the lenders would at least have those funds available to meet their obligations and thus might avoid their own default; in either event, their creditors would be better off. In helping to restore the capital of lenders, or what will become the capital of the creditors of the lenders, quick foreclosures would serve to restore the ability to originate new loans.

Recovery requires the end of financial pretense. There are banks that do not want to see the liquidation of various types of assets that they own, notably, “collateralized debt obligations” (CDOs). These are securities issued against collections of other securities, which in turn were issued against collections of mortgages, an undetermined number of which are in default or likely to go into default. The presumably low prices that such securities would bring in the market would likely serve to reveal the presence of so little capital on the part of many banks that they would be plunged into immediate bankruptcy. To avoid that, the banks want to prevent the discovery of the actual value of those securities. At the same time, they want creditors to trust them. Yet before trust can be established, the actual, market value of the banks’ assets must be established, even if it serves to bankrupt many of them. The safety of their deposits can be secured without the banks’ present owners continuing in that role.

When these various requirements have been met and the process of financial contraction comes to an end, the profitability of business investment will be restored and recovery will be at hand.

Next: Part II: Stimulus Packages


*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.

New York Times Columnist Maureen Dowd Wants Soviet-Style Show Trials with Capitalist Defendants in Shackles

New York Times columnist Maureen Dowd has written a column (January 28, 2009) full of withering hatred and contempt for many of today’s most prominent businessmen, first and foremost the heads of the Wall Street Banks. She singles out Citigroup and Merrill Lynch in particular, denouncing the first for going ahead with taking delivery of a $50 million luxury jet at the very time the firm was losing billions, and the last CEO of the second, John Thain, for spending $1 million to redecorate his office, also in the midst of his firm’s suffering major losses.

Her column leaves the reader with a view of these people and, by implication, of practically the whole economic class to which they belong, i.e., virtually all businessmen and capitalists, as having a mentality that combines the worst features of Marie Antoinette and Nero. The former, of course, was Queen of France until 1793, when she was beheaded. She is famous for allegedly having said in response to being informed of the peasantry’s lack of bread, “Let them eat cake.” And Nero was the Roman emperor who is known for having fiddled while Rome burned, and who died in 68 AD, committing suicide when he learned that the Roman Senate had ordered that he be flogged to death.

Having led her readers to such an assessment of these people, she concludes her column with the declaration, “Bring on the shackles. Let the show trials begin.” If they do begin, Dowd will be there, perhaps with knitting needles, in the role of a modern-day Madame Defarge, the Dickens character who knitted while watching aristocrats being guillotined during the French Revolution.

The day after Dowd’s column appeared, a news story in The Times reported that, “Despite crippling losses, multibillion-dollar bailouts and the passing of some of the most prominent names in the business, employees at financial companies in New York, the now-diminished world capital of capital, collected an estimated $18.4 billion in bonuses for the year. That was the sixth-largest haul on record, according to a report released Wednesday by the New York State comptroller.”

The day after that, President Obama called the bonuses “shameful.”

The Fate of Capitalism

It is very easy to interpret the kind of facts that have been described, as an indictment of the capitalist system, which is exactly how they are being interpreted. Millions of people have lost their jobs; millions more fear that they will lose theirs. These millions cannot avoid the further fear that they and their families will be utterly impoverished. And they are being led to blame their losses on capitalism, in large part by being led to blame it on the persons of individual businessmen or capitalists whom they perceive as hateful.

What is present and being inflamed is the psychology of an angry mob. Its sympathies are with innocent victims who have suffered a great wrong. It’s sure it knows who is responsible and how. The next step will be for someone to yell, “Get a rope!”

Already, businessmen and capitalists are starting to cower in fear. Corporations are racing to get rid of their private jets. Next it will be their private dining rooms and limousines. Private profit and personal luxury at any level are in danger before the onslaught of a collectivist mentality that holds that if many are suffering, all must suffer, and, further, that those who do not suffer are responsible for the suffering of those who do. Anyone whose head is above the crowd will risk being a target.

This is the time for everyone to recall whatever instances in his life that he remembers when angry mobs turned out to be wrong. Perhaps it’s only a scene from a movie or book, in which someone is able to present a few facts that the mob doesn’t know and that begin to place things in a different, calmer light. Let me be that someone now and begin with one very important and fundamental relevant fact.

Today’s Economic System Is A “Mixed Economy,” Not Laissez-Faire Capitalism

And that is that even if all of the facts as presented were absolutely true, it would not imply any reason whatever to condemn capitalism. Capitalism is a system in which absurd, self-destructive behavior severely punishes whoever is guilty of it. Such people suffer losses, go bankrupt, and lose their ability to have significant further economic influence. Their example then serves as a lesson to others to avoid such behavior.

However, we are very far from having capitalism today, certainly not capitalism in its logically consistent form of laissez-faire capitalism. What we have today is a “mixed economy,” that is, a severely hampered, distorted form of capitalism. In such a system, such behavior can continue, thanks to government subsidies, grants of monopoly privilege and suppression of competition, and now by means of government “bailouts.”

A mixed economy is an economy which remains capitalistic in its basic structure, but in which the government extensively intervenes with the initiation of physical force to compel actions that are against the interest of individuals and/or to prohibit actions that are in the interest of individuals. For example, today it compels people to pay an income tax, which is against their interest but which they pay in order to stay out of jail. It also prohibits them from engaging in various business mergers or paying wages below a certain amount, things which it would be to their interest to do but now do not, because they wish to avoid being fined or imprisoned. (In my recent article “The Myth that Laissez Faire Is Responsible for Our Financial Crisis,” I present an extensive description of the extent of government intervention.)

A mixed economy lacks the fundamental moral-political principles that are needed to determine what is proper or improper for a government to do. Its only principle, if one can call it that, is that the government can do anything that enough people believe will accomplish what they think is “good,” according to an undefined standard. Our mixed economy rests on the effective discarding of the United States Constitution, which placed severe limits on government power and thus stood as a bulwark in defense of an economic system that was almost one of laissez-faire. The Constitutional protections were discarded by a process of pretending that the Constitution could somehow “grow” or “evolve,” which actually meant nothing other than choosing to ignore it.

In a mixed economy, every significant-sized business must fear what the government can do to it. It needs protection, in the form of political connections. It secures these through appointing former government officials to its board of directors, paying such officials lavish consulting fees, and giving lavish campaign contributions to candidates for public office. In these ways it buys the protection it needs.

But soon businesses learn that their protectors can also be used to gain lucrative government contracts, government subsidies, and monopolistic privileges ranging from tariffs and licensing laws to antitrust suits against competitors. Thus, it is not long before the upper echelons of large firms become populated not only with men who cower before the government but also with those who seek to manipulate the government to their advantage, which is where we are today.

Certainly not all big businessmen are this way, and probably only a few of those that are, are so through and through. For the most part, they still have real jobs to do in running their companies, and to the extent they simply do those jobs, they are productive. But probably most big businessmen are morally compromised if only because they must live in fear of the government and are helpless to do anything about it.

Responsibility for the Financial Crisis

There is a sense in which an important sub-group of businessmen does have genuine responsibility for the present economic crisis and for all previous crises of financial contraction and deflation. This is the sub-group of commercial bankers.

Ironically, the way in which they have been responsible is by means of doing something that almost everyone very much wants them to do, above all, the government, and even when the crisis comes, still wants them to do or to get back to doing as soon as possible. This something is the practice of credit expansion. Credit expansion is the lending out of new and additional money that is created out of thin air, with the encouragement and support of the government. Governments value and encourage credit expansion both in the mistaken belief that it is a source of prosperity and in the knowledge that it is a ready source of money to finance government spending.

Credit expansion is what creates a delusion of prosperity while it lasts and economic depression when it ends. It is all that needs to be stopped to end the boom-bust cycle. (In this brief article, I must ask the reader who wants to understand the process, and how to stop it, to be content merely with references to further reading, namely, Chapters XX and XXXI of Ludwig von Mises’s Human Action and Chapters 12 and 19 of my own Capitalism: A Treatise on Economics. Concerning the role of credit expansion in our present crisis in particular, please see my articles “The Myth that Laissez Faire Is Responsible for Our Financial Crisis,” “Our Financial House of Cards and How to Start Replacing It With Solid Gold,” and “The Housing Bubble and the Credit Crunch.”)

I want now to deal with the subjects of bonuses and corporate jets.

Bonuses

Granting bonuses to employees and buying jet planes are perfectly legitimate for private business firms. In today’s context, this means firms that have not received government bailout money.

Giving bonuses and buying jet planes are purely business decisions. It’s only a question of whether the bonuses motivate the employees who receive them to bring in profits to the firm that are greater than the bonuses paid, or not. If the answer is yes, then it makes sense to pay the bonuses.

To the chief executive of a privately owned, non-taxpayer supported Wall Street firm, the payment of bonuses even in a year of calamitous losses may appear as still making economic sense, at least if the firm expects to stay in business. This is because the bonuses are not paid to people who have incurred the firm’s losses. Those losses are in the assets the firm owns. They are not in its day-to-day trading operations, which may continue to be profitable.

The situation is analogous to that of a retail chain which has had massive losses because of such things as fire or hurricane damage to its warehouses, but whose stores are still making money. The Wall Street firm is still executing customers’ orders in buying and selling securities, it is still trading in currencies and in the futures markets, and still arranging mergers and acquisitions, and divestitures and breakups. All of these aspects of its business may well still be profitable.

The brokers and traders, the mortgage and acquisition specialists et al., and their various assistants and supporting staffs, have contributed very substantially to these operating profits. The same is true of many of the economic and financial researchers and analysts that the firm employs in connection with its still profitable operations. Money is set aside out of the year-end totals to pay bonuses to the members of such groups, based on their respective individual profitability. The bonuses are accumulated employee compensation, similar in nature to the commissions paid to retail sales clerks. If the firm expects to be in business in the following year, and wants to retain the services of these employees, who, despite the firm’s massive losses in its accumulated assets, have performed well, it probably needs to pay them their bonuses.

John Thain, the then president of Merrill Lynch tried to explain this fact to an interviewer, when he said, “If you don’t pay your best people, you will destroy your franchise” and they’ll go elsewhere, he said.

Ms. Dowd apparently does not know the difference between an operating profit and a balance-sheet loss. She apparently does not know the difference between the due of a successful salesman in a retail-store and the due of someone whose actions have served to burn down the store’s warehouse. But she does know how to be furious. She responded to this explanation by exclaiming:

Hello? They destroyed the franchise. Let’s call their bluff. Let’s see what a great job market it is for the geniuses of capitalism who lost $15 billion in three months and helped usher in socialism.

Despite her ignorance and her collectivism-inspired refusal to draw distinctions between individuals and their respective individual performances and responsibilities, Ms. Dowd does have something of a point. Namely, if because of the bankruptcy and closing of many Wall Street firms, there should be a glut of brokers and traders et al., then the remaining Wall Street firms would be in a position to reduce their compensation. But that would be something they would typically announce before the fact, not after the fact of an agreed-upon compensation having been earned.

***

My discussion of bonuses was in the context of the operations of a privately owned business firm, not one that has to be financially supported by the government and is operated with funds provided by taxpayers. In awarding bonuses after Merrill Lynch’s receipt of government bailout money, which started in September of 2008, Mr. Thain did not realize that he was no longer in charge of a private firm. He did not realize what difference this made to the fundamental character of his firm. Neither did very many other people at the time. But more on this later.

Corporate Jets

I turn now to the subject of corporate jets.

If a corporation can afford to buy a jet and having it will enable extremely high-paid executives to avoid wasting time waiting at airports and be able to be more efficient in working in the time spent in flight, then over time its purchase may actually save more money than it costs. If so, then it will be a good business decision to buy the plane.

It may even be a good business decision to buy it, if the executives who fly in it simply prefer it because it’s more comfortable and enjoyable. In such a case, even if the plane saves nothing in costs or not enough to justify its purchase, it can still make good economic sense for the firm to buy the plane. This will be the case if it is in a position to reduce the compensation paid to the executives in question by as much or more than the amount that it must expend for their personal benefit.

Thus, for example, if the plane falls short of covering its cost through increased productivity on the part of the executives by, say, $1 million per year, the firm will have the benefit of more satisfied executives at absolutely no net cost to itself, if it gets the executives to accept $1million less per year in monetary compensation. In that way, it is the executives who effectively bear the cost of the plane that is otherwise uncovered. And the firm will have whatever indirect monetary gains that may result from better satisfied executives.

Indeed, to the extent that the executives are willing to forgo an amount of compensation that is greater than what is required to cover any otherwise uncovered cost of the plane, the firm has a clear saving in monetary terms. Thus, if the executives can be paid $2 million less per year, while the otherwise uncovered part of the cost of the plane is still $1 million, the firm has a monetary saving of $1 million per year by buying the plane. (Today’s tax laws work in this direction. The replacement of $1 million in monetary compensation with $1 million in indirect compensation, serves to reduce the executives’ after-tax monetary compensation by perhaps as little as $500 thousand, while saving the corporation the full $1 million.)

Situations such as this actually occur all the time, throughout business. Again and again, firms provide fringe benefits that are of value to their employees but which do not cover their cost through increased productivity. They are motivated to provide them by being able to save more in what they would otherwise have to pay the employees in take-home wages than the cost of the fringe benefits.

For example, imagine the situation of employees having to choose between two employers. One of them provides air conditioning. The other does not. In the heat of summer, it is a comparative pleasure to work for the one, and extremely uncomfortable to work for the other. If the employees can earn $1,000 per week by working for the employer who provides air conditioning, and they value that air conditioning sufficiently, then in order to be induced to work for the second employer, they might require a wage of $1,100 per week. If that second employer can provide air conditioning at a cost to himself of, say, $10 per worker per week, then he will save $90 per worker per week if he provides it. Because in that case, he can obtain his workers for a take-home wage of $1,000 plus an air-conditioning cost of $10, instead of for a take-home wage of $1,100 plus no cost on account of air conditioning. Obviously, such conditions compel the employer to provide air conditioning. It is his recognition of such conditions that led the first employer to provide air conditioning to begin with, i.e., simply because employees value having it far more than the reduction in their take-home wages that is needed to pay for it.

This discussion has application to the $1 million office remodeling that so offended Ms. Dowd. Please keep in mind that the remodeling was commissioned in late 2007, when the executive in question started his position. At that time, Merrill Lynch had not yet received any government money and was thus still a fully privately owned company. The executive in question, John Thain, was a man in charge of the use of hundreds of billions of dollars of capital. And, therefore, if he was indeed the right man for the job, which is certainly what was hoped, was easily entitled to compensation at least as far into double-digit millions as that paid to Hollywood movie stars and leading athletes.

With this many millions in compensation, the value to him of $1 million more or less, may not have been terribly great. (Hollywood stars have weddings that cost more.) It may well have been far below the value he attached to spending his hours of working time in an office that was made to personally please him in every possible respect, and which he may have expected to occupy for many years. In such a case, instead of his firm paying him however many millions it otherwise would have paid him, it could pay him a million dollars less, or even more than a million dollars less. In that case, it was he who bore the cost of the office, out of compensation to which, in the judgment of the parties concerned, he was entitled.

Alternatively, it’s entirely reasonable that providing such an office and the optimum working environment that it provided, could be expected to improve his efficiency with respect to deciding the pattern of investment of his firm’s hundreds of billions of dollars of assets. It would not have taken a great deal of such improvement with respect to the use of sums so vast to be able to earn an additional billion or more of profit for his firm. Understanding this, the firm may well have given him his office in the belief that doing so would add vastly more to its profits than the cost of the remodeling.

When Ms. Dowd discussed this million-dollar office remodeling, her reaction was one of incredulity, outrage, and utter contempt. Here’s what she said (referring to an interviewer of the executive):

Bartiromo pressed: What was wrong with the office of his predecessor, Stanley O’Neal?

‘Well — his office was very different — than — the — the general décor of — Merrill’s offices,’ Thain replied. ‘It really would have been — very difficult — for — me to use it in the form that it was in.’

Dowd then asked in a triumph akin to that of crushing a cockroach:

Did it have a desk and a phone?

I can’t help wondering, if when Dowd may need a surgical operation someday, she will be satisfied if her surgeon has a table and a knife.

Bailouts

Government bailouts put everything in a different light. They give everyone in the country the right to second guess every decision of the firms that have received the bailouts, on the grounds that the money used by those firms is theirs, the taxpayers.

Understandably, the taxpayers become furious about things like bonuses, corporate jets, and expensive office remodelings. They see themselves simply as being made to pay for these things. This is because, unlike the shareholders of a private company, the taxpayers will never have any possible financial benefit even if the expenditures might actually be perfectly reasonable and well made if they took place in the context of a privately owned company. And unlike the shareholders of a private company, they were never given a choice about whether or not they wanted their funds to be turned over to this or that company. Their funds were simply seized in order that others might have the means with which to pay bonuses and financially profit from and/or personally enjoy such things as corporate jets and expensive offices.

Bailouts represent a collision between two incompatible modes of operation—between what Mises calls “profit management” and “bureaucratic management.” That is, they represent a collision between operation according to the principle of striving to make profits and avoid losses, which characterizes private business, and operation according to the dictates of rules and regulations, which characterizes government.

The companies bailed out expected to go on operating as private businesses, but with government money. That’s how the bailouts were advertised. But that is impossible.

Once government money enters the picture, the firms are effectively nationalized, even though the outward guise and appearance of private ownership may remain. This is because their operations are no longer based on profit-and-loss considerations but on satisfying the government and whatever sectors of public opinion are loud enough at the moment to influence the government’s decisions.

What precise actions the government will take are unclear at the moment and appear contradictory. For example, the front-page lead article of The New York Times of February 5, 2009 carries the headline “Executive Pay Limits Seek to Alter Corporate Culture,” followed by the subhead, “Obama Announces a $500,000 Cash Cap at Companies Getting Future Aid.”

Nevertheless, a careful reading of the article shows that $500,000 is a limit only on annual salary. Payment of stock options will still be possible, but they will not be able to be exercised until all of the company’s debt to the government is repaid. Even the limit on annual salary appears to be not very firm. In most cases, it can apparently be waived by means of a “nonbinding shareholder vote.”

The article declares,

Even the new rules allow companies some leeway. While giving shareholders a say in bonuses above the cap and restricting when stock incentives can be cashed in, the rules do not place limits on the size of such awards, which have become the biggest part of many compensation packages. In addition, the toughest new rules apply only to large companies seeking government assistance to survive…. And companies that seek aid but do not need exceptional government assistance can waive the $500,000 pay cap, as long as they submit their executive pay policies to a nonbinding shareholder vote.

Very significantly, the article notes that

The rules would not prohibit a lower-level executive, like a stock trader or investment banker, from continuing to receive tens of millions of dollars in pay. (My italics.)

If this last is true, then one must wonder exactly what the brouhaha about bonuses was all about in the first place. Because, with this last provision, they appear to be back in, almost in full force.

The current version of the proposed pay caps is clearly contradictory and bound to disappoint Wall Street’s critics. It reads like a compromise forged of a competition between whose lobbyists could get to which politicos with the largest bribes or greatest threats first. At this point, there is no telling what the final proposal will look like. The Times’s article notes that “Officials also emphasized that several of the proposals would not be made final until after public comments had been considered.”

What would be required to satisfy the rhetoric of Wall Street’s critics would be the total abolition of bonuses and a maximum limit on total executive compensation in the nationalized firms to $500,000 for any one individual. That, of course, would mean the destruction of the nationalized firms as viable institutions.

With such a level of compensation, further discussion of such things as corporate jets and expensive office remodelings would disappear, at least as far as the nationalized firms were concerned. This is because the low pay ceilings on executive salaries, and thus the kind of low quality executives likely to be attracted, would eliminate the context in which an economic calculation could justify the purchase of a jet or an expensive office remodeling.

Executives whose salaries are limited to $500,000 are not going to be able to afford to accept the kind of reduction in take-home wages that would be necessary to cover any significant part of the cost of providing a jet or an expensive office remodeling. Nor is any enhanced productivity of such executives likely to be great enough to justify the cost. The head of a government controlled firm may inherit a luxurious office but all that he can afford or that can be afforded on his behalf is not very much more than a desk and a phone—and volumes of rules and regulations that he can consult and scrupulously follow, in order to be able to prove that whatever losses may strike his firm were not his fault.

But the destruction of bailouts is not limited to the crippling of the firms that are bailed out. It also taints the operations of the firms that are operating without bailouts. As already pointed out, they too have given up their jets and are keeping their heads down, despite the fact that economic rationality implies that they should keep their jets. They have been cowed by a raging hostility toward capitalism and wealth.

Symbolism

I quote the words of a prominent New York Times reporter, who sees the facts of the situation, even describes some that I omitted, and yet approves of what has happened. He writes:

When you get right down to it, the purchase of a new plane or an office renovation is pretty meaningless for companies as large as Citigroup or Bank of America [Merrill Lynch is now part of Bank of America]. It’s not unheard of for executives to spend $1 million or more on remodeling when they get the corner office. It’s pocket change. And companies can usually make a halfway decent business case to justify a new airplane. (It goes longer distances than older planes, can take more executives to meetings, allows the top brass to be more efficient and productive, etc., etc.) The question of whether bailout money was used to pay for these perks — as alleged by The New York Post, which broke the Citi airplane story — is, at best, ambiguous. Indeed, breaking the airplane contract and sending the jet back to the manufacturer will probably
cost the bank more than keeping the plane. None of that matters. You could make the same argument about the auto executives who flew on corporate jets when they came to Washington to ask Congress for help: surely, it was a better use of their time to fly rather than drive from Detroit, as they did the second time around, after being spanked for taking the jets. That didn’t matter either. What matters is the symbolism. At a time when the country is in such trouble — and executives are asking for bailouts — anything that smacks of plutocracy is going to arouse justifiable populist anger. (Joe Nocera, “It’s Not the Bonus Money. It’s the Principle,” New York Times, January 31, 2009, p. B1. My italics.)

So here we have it. What the outrage is really all about is the hatred of great wealth and its possessors. The goal is to attack them in the name of an alleged duty of the individual to sacrifice his wealth, pleasure, and enjoyment, and ultimately his life, for the benefit of others less fortunate. Seen in this light, the furor raised about corporate jets, office remodelings, and the like is understandable. It is the kind of symbolism appropriate to a campaign on behalf of self-sacrifice and against the pursuit of happiness.

In sharpest contrast and opposition to the philosophy of self-sacrifice and to the role of government as the enforcer of sacrifice, stand these famous lines:

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. — That to secure these rights, Governments are instituted among Men….

These words are from the Declaration of Independence, which is the founding document of the United States. Their meaning is that the United States was established for the purpose of securing the right of the individual to pursue his own happiness, which includes material prosperity. In the United States, the individual and his rights are supreme. Government exists only in a subordinate role, that of a servant dedicated to protecting and securing the individual and his rights from the aggression of common criminals at home and of despots abroad.

What symbolism would be appropriate to this conception of the relationship between the citizens and their government? How would it differ from the present such symbolism?

The present symbolism depicting the relationship between the government and the citizen is that the head of the government, the President of the United States, has at his disposal, with no objection from anyone, Air Force One, which is a Boeing 747 jet plane that costs hundreds of millions of dollars and, when configured for commercial operation, carries more than 450 passengers. At the same time, howls of anger and fury go up when one of the largest private corporations in the country dares to order a 12-seat jet plane for $50 million.

The acceptance of this relationship symbolizes the total reversal of the relationship between government and citizen that the founding of our country was intended to establish and maintain. The symbolism appropriate to that relationship would be that while private citizens are free to fly in 747s, or Lunar Landers for that matter, depending only on how successful is their individual pursuit of happiness, the President of the country, who is merely the chief night watchman of the nation, and is its servant, is consigned to a 12-seater jet.

Of course, this is not to begrudge the President of the United States the use of a 747 in today’s world, in which he may require such a plane merely in order to have necessary means of communication at his disposal. But it is to remind all those seeking to deify the government and raise it above the citizens, that they are encouraging a servant to forget his place and to become the master of those whom it is his duty to serve.

Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title, above, and then saving the file when it appears on the screen. The book provides further, in-depth treatment of the substantive material discussed in this article and of practically all related aspects of economics.

DOES OBAMA WANT TO LYNCH RUSH LIMBAUGH?

My answer to the question “Does Obama Want to Lynch Rush Limbaugh?” is, no. He and the rest of the Left just want to drive Rush Limbaugh off the air.

Obama has already used the prestige of his office to attack Limbaugh by name. According to The New York Post and Fox News of January 23,

WASHINGTON -- President Obama warned Republicans on Capitol Hill today that they need to quit listening to radio king Rush Limbaugh if they want to get along with Democrats and the new administration.

"You can't just listen to Rush Limbaugh and get things done," he told top GOP leaders, whom he had invited to the White House to discuss his nearly $1 trillion stimulus package.

To get the silence-Limbaugh campaign going, the Democratic Congressional Campaign Committee yesterday (January 27) launched a petition drive urging people to “EXPRESS [THEIR] OUTRAGE ABOUT RUSH’S COMMENTS” that stated his hope that Obama’s socialistic plans will fail. This followed a warm up led by assorted news anchors, pundits, and celebrities denouncing Limbaugh in the media.

Here’s is what Limbaugh actually said, back on January 16, and which led to the orchestrated campaign now being waged against him:

I've been listening to Barack Obama for a year-and-a-half. I know what his politics are. I know what his plans are, as he has stated them. I don't want them to succeed.

If I wanted Obama to succeed, I'd be happy the Republicans have laid down. And I would be encouraging Republicans to lay down and support him. Look, what he's talking about is the absorption of as much of the private sector by the US government as possible, from the banking business, to the mortgage industry, the automobile business, to health care. I do not want the government in charge of all of these things. I don't want this to work..… Why is it any different, what's new, what is unfair about my saying I hope liberalism fails? Liberalism is our problem. Liberalism is what's gotten us dangerously close to the precipice here. Why do I want more of it? I don't care what the Drive-By story is. I would be honored if the Drive-By Media headlined me all day long: "Limbaugh: I Hope Obama Fails." Somebody's gotta say it.

Actually, as Limbaugh well knows, it’s really not necessary to hope for the failure of Obama’s socialistic policies themselves. If they are adopted, they will fail by virtue of their own nature. But it is perfectly reasonable to hope for the failure of Obama’s efforts to get his policies enacted and to hope that to the extent they are enacted their failure is recognized. This is what Limbaugh clearly meant.

The Left cannot tolerate criticism or dissent. A large proportion of its members are actually Stalinist in their mentality. (This is a far larger proportion than the members of the right who are in favor of the diametric opposite of Stalinism, namely, laissez-faire capitalism, which the Left attacks more and more stridently.)

Serous Leftists, i.e., those who want to establish and maintain actual government ownership or control over the economic system are all implicitly totalitarians. On the one hand, they want to take total control over people’s lives under the pretext of improving and enriching their lives. But their policies are so bad, cause so much destruction and human suffering, that the potential is created for an explosive outburst of hatred and vengeance against them once the public draws the logically inescapable conclusion that it is they and their policies who are responsible. To stay in power and keep socialism in existence, they have to prevent this from happening by crushing all possibility of dissent.

Limbaugh is a major thorn in the side of the Left. They need to remove him, because his criticisms serve to slow their advance and might even help to stop them in their tracks.

That’s why I’m for Limbaugh and I too hope Obama fails at every turn in his efforts to expand the powers of government.

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen.

FALLING PRICES ARE NOT DEFLATION BUT THE ANTIDOTE TO DEFLATION

This is the first in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity.

A disastrous economic confusion, one that is shared almost universally, both by laymen and by professional economists alike, is the belief that falling prices constitute deflation and thus must be feared and, if possible, prevented.

The front-page, lead article of The New York Times of last November 1 provides a typical example of this confusion. It declares:

As dozens of countries slip deeper into financial distress, a new threat may be gathering force within the American economy—the prospect that goods will pile up waiting for buyers and prices will fall, suffocating fresh investment and worsening joblessness for months or even years.

The word for this is deflation, or declining prices, a term that gives economists chills.

Deflation accompanied the Depression of the 1930s. Persistently falling prices also were at the heart of Japan’s so-called lost decade after the catastrophic collapse of its real estate bubble at the end of the 1980s—a period in which some experts now find parallels to the American predicament.

Contrary to The Times and so many others, deflation is not falling prices but a decrease in the quantity of money and/or volume of spending in the economic system. To say the same thing in different words, deflation is a general fall in demand. Falling prices are a consequence of deflation, not the phenomenon itself.

Totally apart from deflation, falling prices are also a consequence of increases in the production and supply of goods, which are an essential feature of economic progress and a rising standard of living. In such circumstances, falling prices are not accompanied by any plunge in business sales revenues or profits, by any increase in the difficulty of repaying debt, or by any surge in bankruptcies. All of these phenomena are the result purely and simply of deflation, not falling prices.

Indeed, under a full-bodied, 100-percent-reserve gold standard, falling prices, caused by increased production, are likely to be accompanied by a modest elevation of the rate of profit and a somewhat greater ease of repaying debt, both owing to the increase in the production and supply of gold and thus in the spending of gold. Under such a gold standard, prices fall to the extent that the increase in the production and supply of ordinary goods and services outstrips the increase in the production and supply of gold and the consequent increase in spending in terms of gold.

While this must certainly come as a surprise to The Times, and to everyone else who does not understand the nature of deflation, falling prices are in fact so far removed from being deflation that they are the antidote to deflation. They are what enables an economic system that has experienced deflation to recover from it and thereafter to enjoy the fruits of economic progress.

This conclusion can be demonstrated Socratically, by means of a simple question that could be used on an economics exam for sixth graders.

Thus, imagine that prior to the present financial downturn, Bill used to go shopping once a week in his local supermarket. When he went there, he could afford to spend $10 for bottled water. At the prevailing price of $1 per bottle, he was able to buy 10 bottles. Now, in the midst of the downturn, when Bill visits the supermarket, he can afford to spend only $5 for bottled water.

Here’s the question: At what price per bottle of water would Bill be able to buy for $5 the 10 bottles of water he used to buy for $10? Answer: 50¢.

As this question and its answer make clear, a fall in prices enables reduced funds available for expenditure to buy as much as previously larger funds could buy.

This point applies even when lower prices do not result in greater purchases of the particular item whose price has fallen. Thus, suppose that the price of a gallon of milk is $8 and now falls to $4. Yet Bill and his family do not need more than one gallon in any given week, and so won’t buy any larger quantity of milk at its now lower price. The fall in its price still helps economic recovery. It does so by freeing up $4 of Bill’s funds to make possible the purchase of other things, that he wants but otherwise couldn’t afford because of the lack of available funds.

Another, similar example is that of a fall in the price of gasoline or heating oil, which helps to increase the ability of people to spend in buying products throughout the economic system.

As indicated, in sharpest contrast to falling prices, deflation is a process of financial contraction. In our present crisis, it is a contraction of credit and of the spending that depends on credit. A fall in prices and, of course, in wage rates too, is the essential means of adapting to this deflation and overcoming it.

Nevertheless, the prevailing bizarre confusion of falling prices with deflation, stands in the way of economic recovery. In regarding falling prices, which are the effect of deflation and at the same time the remedy for deflation, as somehow themselves being deflation, people are led to confuse the solution for the problem with the problem that needs to be solved.

On the basis of this confusion, they advocate government intervention to prevent prices from falling. The prices they want to prevent from falling are, variously, house prices, farm and other commodity prices, and, above all, wage rates. To the extent that such efforts are successful, and prices are prevented from falling, the effect is to prevent economic recovery. It prevents economic recovery by preventing the reduced level of spending that deflation represents, from buying the larger quantity of goods and services that it would be able to buy at lower prices and wage rates.

Just as falling prices are so far from being deflation that they are the remedy for deflation, so too preventing prices from falling is so far from preventing deflation that it actually worsens the deflation. This is because it leads people to postpone buying even in instances in which they have the ability to buy. They put off buying in the expectation of being able to buy on better terms later on, when prices and wage rates have fallen to the extent necessary to permit economic recovery.

By the same token, when prices and wage rates finally do fall sufficiently to permit economic recovery, an increase in spending in the economic system will almost certainly occur. This is because the funds that people had been withholding from spending, awaiting the fall in prices and wages rates, will now, in the face of the necessary fall, be spent. Thus the necessary fall in prices and wage rates achieves economic recovery by means of creating greater buying power for a reduced amount of spending. It also brings about a partial restoration of spending and thereby definitively ends the deflation.

Just how far it is necessary for prices and wage rates to fall in order to achieve economic recovery depends on the change that has taken place in what Mises calls “the money relation.” This is the relationship between the supply of money and the demand for money for holding.

During the boom, inflation and credit expansion increase the supply of money and at the same time reduce the demand for money for holding. Then, in the subsequent bust phase of the business cycle, the demand for money for holding rises and the supply of money can actually fall. Both of these factors make for a decline in total spending in the economic system and thus the need for a correspondingly lower level of wage rates and prices to achieve economic recovery.

How far these processes might go in our present circumstances and what might be done, consistent with the principle of economic freedom, to mitigate them, is too large a subject to explain in this one article.[1] However, I must state here that a decrease in the quantity of money can be altogether prevented and that this would dramatically limit the extent of the decline in overall spending in the economic system.

Whatever the reduced levels of spending that the changed money relation will support, the freedom of wage rates and prices to fall can achieve not only economic recovery but more than economic recovery. It can achieve the employment of everyone able and willing to work, i.e., full employment. And it could do so with no decline in the real wages of the average worker in the economic system, indeed, with a significant rise in his real wages. Unfortunately, this too is a subject too large to discuss further in the present article.[2]

Bailouts

Before closing, I must say a few words about the present efforts of the government to overcome the crisis by means of “bailouts” and their associated financing by budget deficits. Ultimately, these efforts are an attempt to overcome the effects of a rise in the demand for money for holding by means of a sufficiently large increase in the supply of money. In its campaign, the government appears to care for nothing but overcoming the crisis of the moment, without regard to the fuel it is providing for the next crisis.

The government today has unlimited powers of money creation. And so it is highly likely, given its evident willingness to use those powers, and the overwhelming public support that exists for using them, that the increase in the supply of money it brings about will ultimately outweigh the present increase in the public’s demand for money for holding. When and to the extent that that happens, and business sales revenues and profits begin to rise and employment and wage rates begin to rise, the public’s demand for money for holding will once again begin to fall.

At that point the massive increase in the quantity of money the government is currently bringing about will fuel sharply rising prices and give birth to a new crisis. This time, a crisis of inflation. Then, the government will either have to be content with a US economy that resembles the economic system of a Latin American country or it will have to rein in its inflation. If it chooses the latter quickly, we’ll be back to the situation that prevailed in the early 1980s and have to undergo a fresh economic contraction, though probably one of much greater size than then, because of the unfinished business left over from the present crisis.

If the government delays too long in reining in its inflation, then when it finally does decide to do so, it may be confronted not only with prices rising as rapidly as they did in Latin America decades ago, but also with the massive unemployment rates that accompanied the efforts to rein in such major inflation. At that time, prices rising at a rate of 20, 30, or 50 percent or more were accompanied by comparably high unemployment rates. (To understand how such a thing can happen, imagine total spending and prices both rising at the rate of, say, 50 percent per year. Now the government, in an effort rein in inflation, succeeds in reducing the increase in spending to 15 percent. If the rise in wage rates and prices has any kind of significant inertia, such as continuing at 40 percent, the effect will be a drop in production and employment to a level equal to 1.15/1.4, which represents a drop of about 18 percent. In the nearer-term future, unemployment will be promoted by any additional powers the government may give to labor unions, who will use them to raise wage rates even in the midst of mass unemployment, as they did from 1932 on in the Great Depression.)

Of course, given the prevailing readiness massively to expand the powers of government in order to deal with short-term crises, it is also possible that the government will enact wage and price controls in its efforts to fight the consequences of its inflation. If and when the controls are subsequently removed, there will again be a crisis of rising prices that, if not accompanied by still more inflation, will be followed by a major financial contraction. If the price controls are not removed, the economic system will be paralyzed and ultimately destroyed.

The upshot is that there is no good way out of the present crisis other than by meeting it through the free-market’s means of a fall in wage rates and prices, mitigated to the maximum extent possible in ways consistent with the principle of economic freedom. What is required is a way out that once and for all ends the boom-bust cycle of inflation and credit expansion followed by deflation and contraction. The free market, a freer market than we have had up to now, is the only such solution.

Economic freedom and economic recovery both require that prices and wage rates be free to fall and that all legal obstacles in the way of their falling be immediately removed. In order for that to happen, as many people as possible must understand that falling prices are not deflation but the antidote to deflation.

***

Postscript: Two points need to be briefly addressed that I could not deal with in the body of my article. One concerns the effect of the prospect of falling prices on the postponement of expenditures. This postponement applies only to the case in which the fall in prices is in response to a fall in demand, not an increase in production and supply. In this case, if prices do not fall, demand falls further, as I showed.

However, the prospect of falling prices resulting from increased production and supply does not imply a postponement of purchases. This is because in this case the prospective fall in prices is not the result of any decrease either in spending or in any other major monetary aggregate. On the contrary, here the prospective fall in prices means an increase in the prospective buying power of all accumulated savings as well as of the income that will be earned in the future. In this way, the process of economic progress portends being financially better off in the future than in the present. The effect of this in turn is to enable people to afford to consume more in the present. This counterbalances the benefit to be derived by waiting to take advantage of lower prices in the future. In other words, falling prices due to increased production and supply are essentially neutral in their overall effect on the relationship between spending for present consumption versus saving for future consumption.

The second point that needs to be addressed concerns housing prices. It is often asserted that falling house prices are responsible for bank failures and that the continuation of falling prices for housing must result in more such failures and therefore must be stopped.

Falling home prices are not in fact responsible for bank failures, any more than falling prices of aging automobiles are responsible for bank failures. The fact that homeowners may owe more on their homes than their homes are worth has no more fundamental connection with defaults on mortgage loans than the fact that many or most automobiles purchased with installment loans are worth less than the outstanding loan balances owed on them. Indeed, the mere act of driving a new car off the dealer’s lot is often sufficient to put its resale value below the value of the outstanding loan balance on the car.

What leads to defaults, whether on home loans or on automobile loans, is the inability or unwillingness of borrowers to honor their financial obligations, not the market value of the homes or cars.

Only decades of inflation and credit expansion could make it possible for people to think of the houses they occupy as an investment. In reality, a house is a consumers’ good, just like an automobile or a refrigerator. The only difference is that it depreciates more slowly than they do. Only a long string of years in which inflation took place more rapidly than houses depreciated enabled their prices to rise every year and people to come to regard them as a source of financial gain. If not for inflation and the rise in prices that it produces, it would be very clear that housing is a wasting asset, a slowly wasting asset to be sure, but a wasting asset nonetheless.

If not for inflation, the price of new houses would not rise. They would probably even fall from year to year. In addition, the price of a house that was 5, 10, or 20 years old would be significantly less than the price of a new house. Thus even constant prices of new houses, let alone falling prices of new houses, implies that the price of a house declines as it ages. That is the normal situation. That is the situation in the absence of inflation.

The accelerated credit expansion of recent years and the rapid rise in house prices that it caused made it appear for a while that it was profitable to buy houses for no other reason than quickly to resell them. It also made it appear that people could live off the rise in equity in their homes, by borrowing against it. The frenzy of the housing bubble was such that at its peak the price of the median house could be afforded only by people earning the top 15 percent of incomes.

There is no reason to attempt to maintain artificially high house prices and to rescue the borrowers and lenders who were responsible for them. Furthermore, the attempt to do so must perpetuate the suspicion that the lenders are still basically unsound and cannot be counted on to be able to meet their own financial obligations. Such bad loans must be owned up to and cleared off the books of the banks and the other financial institutions that made them, before confidence can be restored in the financial system.

The fall in housing prices that is taking place needs to go further. The median home price is still considerably higher than the median income level. Calls for stabilizing house prices are a demand for government intervention on behalf of reckless borrowers and lenders, paid for by taxpayers.

The lower home prices that will result from the freedom of the housing market from government interference will reduce the size of the mortgages that are necessary to buy homes. If a house sells for half a million dollars instead of a million dollars or for one-hundred thousand dollars instead of two-hundred thousand dollars, then the amount of mortgage financing required to buy it is correspondingly reduced and the housing market comes into alignment with the reduced overall supply of credit that is available.

[1] For a discussion of the subject, see the author’s Capitalism: A Treatise on Economics, pp. 959-962.

[2] I have discussed it at length in Capitalism; see pp. 580-587.

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.

Larry Summers: Heavyweight Centrist or Lightweight Leftist?

A recent New York Times article provides two significant pieces of information about Larry Summers, the man designated by President-Elect Obama to be head of the National Economic Council and, as such, according to The Times, “his lead economic adviser inside the White House.” (David Leonhardt, “The Return of Larry Summers,” November 26, 2008, p. B1.)

First, The Times’ article informs its readers that Summers, a former Secretary of the Treasury under President Clinton, and later President of Harvard University, so impressed Henry Kissinger that years ago “Kissinger suggested that Mr. Summers be given a White House post in which he was charged with shooting down or fixing bad ideas. Mr. Summers’ loyal protégés — Timothy Geithner, who beat him out to become the next Treasury secretary; Peter Orszag, the next budget director; Sheryl Sandberg, the chief operating officer of Facebook; and others — say that Mr. Summers can make them smarter in ways that almost no else can.”

The second significant piece of information provided by The Times’ article describes the nature of Mr. Summers’ own ideas. It describes how “His favorite argument today…goes like this: To undo the rise in income inequality since the late ’70s, every household in the top 1 percent of the distribution, which makes $1.7 million on average, would need to write a check for $800,000. This money could then be pooled and used to send out a $10,000 check to every household in the bottom 80 percent of the distribution, those making less than $120,000. Only then would the country be as economically equal as it was three decades ago.”

The Times’ reporter has apparently known about Mr. Summers’ redistributionist ideas, as well as his closeness to Mr. Obama, for at least a year and a half. As a professional journalist, he had a moral obligation to share such important knowledge with the general public. But he, and many others, similarly so informed, did not bother to do so. Instead, even in the face of the substantial public upset in connection with the question about redistribution posed to Mr. Obama by the now famous “Joe the Plumber,” they chose to remain silent.

They personally favored the election of Mr. Obama and his ideas on the subject of redistribution. Badly lacking in professional standards and personal morals, they placed their own political agenda above their professional obligation to inform the public about a matter vital to an intelligent decision as to how to cast its ballots.

And now, when they openly describe the redistributionist egalitarianism of Mr. Summers and, implicitly, Mr. Obama, they try to make a far-left agenda more palatable by depicting these gentlemen as belonging to the “center” of the political spectrum.[1]

Summers apparently does not see, or if he does see, does not care, that in presenting his proposal for redistribution, what he is urging is armed robbery on a massive scale. That is the essence of any policy of “redistribution,” whether advocated by Summers and Obama or by Lenin, Stalin, or Mao.

For what is going to make each of the top 1 percent of income earners pay an extra $800,000 in taxes? The only thing that would make them pay it is fear of being arrested and imprisoned. And who will arrest and imprison them? Armed thugs wearing the uniforms and badges of officers of the United States Government, who would give them no other choice but to pay the money or be hauled off to jail and clubbed or shot if they resisted. (What a total perversion this would be of what the United States Government once stood for: a transformation from an institution designed for the protection of individual rights into a gang of bandits massively violating individual rights.)

How does this differ in any essential respect from those who are to receive the loot, in the form of $10,000 checks, taking matters into their own hands and simply robbing the homes and businesses of the top 1 percent of income earners to the extent of $10,000 each? They would give the homeowners and businessmen the same choice, of their money or their lives.

And why should it stop at $800,000 in extra taxes and $10,000 each for the looters? If the economic inequality represented by that $800,000 per capita of the top 1 percent of income earners must be done away with, why should not all economic inequality be done away with? Why not make everyone an equal owner and equal income recipient, i.e., why not go straight for communism? That’s the logic in what Summers is advocating.

Not only is Summers advocating the kind of evil committed by criminals, but he also displays a degree of lack of thought that is often found among criminals.

One of the implications of his proposal is that an individual who increased his earnings by just one dollar could be liable for an additional $800,000 in taxes. Based on the most recent available data, which are for 2006, an individual who increased his earnings from $388,806 to $388,807 would thereby be thrust into the top 1 percent of income earners and thus be made subject to the $800,000 of additional taxes urged by Summers. This, of course, would leave such an individual with an after-tax income of minus $411,193. (In addition, of course, all of the ordinary income taxes for which he would be liable at that level of income would also have to be subtracted, throwing him still further into Summers’ Alice-In-Wonderland world of negative after-tax income.)

Summers is probably unaware of this, because he appears to focus on the $1.7 million average income of the top 1 percent of income earners. This enables him to ignore all the below-average incomes of members of that group that would be rendered negative on an after-tax basis if his scheme were imposed.

A proposal this hare-brained makes Summers come across more as an intellectual lightweight than as any kind of brilliant thinker able to identify the errors in others’ thoughts.

There is actually a reason for Summers’ advocating a scheme that implies negative after-tax income for many upper income taxpayers. That’s the fact that that is what is necessary to make it appear that redistribution can constitute any kind of significant gain to large numbers of people. If one rules out taxes that imply negative after-tax income, and also taxes that serve to reduce the demand for labor or capital goods, it turns out that there is very little to “redistribute.”

First of all, all of the wealth of businessmen and capitalists that is in the form of capital (which in the case of large businessmen and capitalists, is almost all of their wealth) already benefits the entire population. It does so by virtue of serving to produce the goods and services that everyone buys and by virtue of constituting the source of the demand for the labor that wage earners sell.

The wealth of Exxon, General Motors, Dell, etc. is in the means of production that bring gasoline and heating oil, automobiles and SUVs, computers and monitors to the masses. Their wealth and that of all other firms is also the source of the demand for the labor that wage earners sell. Thus there is a twofold general benefit from privately owned means of production: the benefit to the buyers of products and to the sellers of labor.

Exactly the same is true of profit and interest income and of capital gains and inheritances to the extent that they are saved and invested, which, in the case of large incomes and inheritances is overwhelmingly the case as a rule. The only special benefit of the businessmen and capitalists, i.e., the only benefit that they obtain which the non-owners of the means of production do not obtain, is the additional personal consumption that their wealth makes possible, plus the satisfaction of knowing that if necessary they could consume their wealth.

The truly personal consumption of businessmen and capitalists is insignificant in the scheme of things. For Warren Buffet, the world’s richest man, it appears to be on the order of an extra ice-cream soda per billion dollars of additional capital accumulated, plus mosquito nets to fight malaria in Africa. The few dozen or even few hundred mansions, yachts, and personal jets of other very wealthy businessmen and capitalists, pale into insignificance alongside the tens of millions of ordinary homes, automobiles, refrigerators, freezers, washer-dryers, air-conditioners, television sets, and computers of the general population. A major, probably the greater part of the consumption of the leading businessmen and capitalists takes the form of the support of such institutions as universities, hospitals, opera companies, libraries, and the like. When all this is taken into account, it turns out that in the first place there is simply not very much to redistribute that the intended beneficiaries of the redistribution do not already have.

It also turns out that attempts to redistribute the wealth of businessmen and capitalists serve almost entirely to reduce the supply of means of production and the demand for labor. It is a self-destructive policy of eating the seed corn. Summers and Obama are ignorant of such facts. Never having studied the works of Mises, they have no way of knowing them. (For elaboration of these points, see the author’s Capitalism: A Treatise on Economics, pp. 297-303, 622-639.)

It speaks volumes that apparently no one to whom Summers presented his “favorite argument” had the ability to find any moral or practical flaws in it.

Summers should be fired. He’s too shallow and ignorant and his ideas too evil for him to serve in the United States Government in any capacity. Although generally viewed as a prominent professional economist, his actual knowledge of the subject is minimal. This conclusion follows from the fact that the essential subject matter of economics is capitalism. And Summers' ideas on redistribution reveal that he fails to understand the nature of the most essential feature of capitalism, namely, private ownership of the means of production and the indispensable role it plays in the standard of living of the average person.

His views may qualify him to be an economic advisor to Hugo Chavez of Venezuela or Robert Mugabe of Zimbabwe, but certainly not to be an economic advisor to the President of the United States. Before anyone assumes that position, he should know and understand the ideas of Ludwig von Mises, who is far and away the leading theorist of capitalism, and whose works explain its operation as it is has never before been explained. In the absence of extensive knowledge of Mises, one is, simply put, an economic ignoramus, irrespective of the degrees, awards, and public acclaim one may enjoy.

[1] These are the same kind of reporters who define laissez-faire capitalism in an equally bizarre way. Just as you supposedly can be an egalitarian and a Marxist and still be a centrist, so too you allegedly can have virtual economic fascism and it will still be laissez-faire capitalism. And it will be laissez-faire capitalism which is then blamed for all of the evils of economic fascism. Thus, irrespective of the present-day magnitude of taxation and government control over economic life, irrespective of the massive government intervention in the form of credit expansion and of laws compelling the making of loans to unqualified borrowers, which in fact caused our present financial crisis, laissez-faire, they say, still existed and it is what is responsible for the crisis. They claim that laissez faire existed because financial innovations were able to take place without their first being thoroughly understood by government bureaucrats and only then being allowed to occur. Never mind that the major flaw in the innovations was the mistaken belief, held almost universally, but first and foremost by government bureaucrats and by their allies in the media, that the Federal Reserve had made the existence of depressions impossible. (For elaboration on the attempt to blame the crisis on laissez-faire, see the author’s “The Myth that Laissez Faire Is Responsible for Our Financial Crisis.”)



Copyright © 2008, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen.