Economics in Wonderland
This week’s EconTalk podcast featured Prof. Steve Fazzari talking about Keynesian economics. Prof. Fazzari was rather unflinching in his devotion to Keynesianism, and was a very good expositor of his point of view. After listening to the podcast, I feel like I have a much better grasp on some key Keynesian concepts and arguments than I did before. Unfortunately (for Keynes) this newfound clarity hasn’t raised my estimation of the essential validity of Keynes’ ideas. Just the opposite. Listening to the podcast, I increasingly felt like I had slipped into an economic bizzaro-world* where up was down, bad was good, and paying people to dig holes and then fill them up again was a great way to stimulate the economy.
To give an example of what I’m talking about, consider the paradox of thrift. Suppose that a family decides to save more and so stops eating out at their favorite restaurant. All else being equal, you might suppose that total savings would increase, while total consumption would fall. But, says Prof. Fazzari, you are forgetting that by not eating out, the family has destroyed a portion of the income of the restaurant owner. As such, he is faced with the choice of either reducing his consumption (defined to including spending on his business) or to reduce his savings. If he reduces his consumption, then this will simply foist the problem off on some third party, who then will face the same choice of reducing consumption or savings by the same amount. But if he reduces his savings then overall savings won’t go up, as the increase in savings by the family will be offset by an equal decrease in savings by the restaurant owner. Ultimately, then, overall savings won’t increase, and indeed can’t increase, at least if we are holding total income constant.
If this argument seems persuasive to you (as it did to me for about 20 minutes or so), consider that, from the restaurant owner’s perspective, it doesn’t matter what the family does with the money it is no longer spending at his restaurant. They may save it, use it to go to the movies instead, or just give it to the poor; the effect on his income will be the same. So if Prof. Fazzari is right that the restaurant owner in the example above must respond by decreasing his savings when the family stops spending money at his restaurant in order to save, so by parity of reasoning he must also reduce his savings when they stop spending money at his restaurant in order to spend it on something else. Thus, the implication of Prof. Fazzari’s argument is that whenever people change their consumption habits, total savings must go down (holding total income constant). And that’s not just bizarre, it’s bizarro.
Now you might say that the case of the family that skipped dinner to go to the movies is not really the same as Prof. Fazzari’s example, since in this second case there is a third party (the owner of the movie theater) whose income will increase by the same amount as the income of the restaurant owner decreases, and who therefore will be able to offset any decrease in consumption spending or saving by the restaurant owner. But the same is true of Prof. Fazzari’s example as well. After all, when a family decides to save more, they aren’t going to just keep the extra cash stuffed in their mattress. They will either invest it directly, or they will put the money in a bank, which will then in turn loan it out to some other party. In either case, the ultimate receiver of that money will have his income go up, and will be able to “fill the gap” in spending caused by the lost income of the restaurant owner.
Once you realize that (at least in a modern economy) saving is just another form of spending the whole “paradox of thrift” disappears. And insofar as such ideas provide the argumentative foundations for Keynesianism, then the whole system would seem to be based on little more than a muddle.
*Yeah, I know the title says Wonderland, not bizzaro-world. So sue me.
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But isn’t the money being saved just sitting in accounts right now because banks are trying to have lower asset ratios, so they’re limiting their loans. Thus, a penny saved is not a penny loaned. It’s a haypenny loaned, perhaps. And some people save (not as many as in Keynes’s time, of course) in cash, so that money isn’t being loaned at all.
Prof. Fazzari’s claim was that raising total savings (while holding total income constant) was a “logical fallacy.” If one wants to abandon this claim in favor of something weaker, then that’s fine, but it was the stunning boldness of Prof. Fazzari’s position (which he at least claims is “fairly standard”) that prompted this post.
Another example of academics having no idea of how the real world works.
I heard this episode last week and it has been rattling around in the back of my mind ever since. What I found somewhat disconcerting with regard to Keynesian economics (from the admittedly very little I was able to get from a podcast!) is that it seems to found the health of the economy on ever increasing spending and consumption. Since I heard the broadcast, I’ve been trying to track down books that might pursue a link between Keynesian economic practices and the rise of consumerism, I’ve been able to find some interesting leads (one called Consumer Culture Reborn) which I will check out from the Cal library as soon as I get a chance.
The problem (as Keynes pointed out) is that savings and investing are two different functions, and that an increase in savings is not necessarily an increase in lending, or even a lowering of interest rates. In fact, thrift in a capitalist society–or any society where there is a lack of equity–can indeed by a drag on the economy.
This is especially true in an economy where money is created by lending it. The hardest thing to understand is that banks do not lend out deposits; they create deposits by lending them. Before you sign the note for your home or your car, or the credit slip for that hamburger at MacDonald’s, the money does not exist; it is created in the act of lending. This is called “fractional reserve banking,” and even this title is misleading, since reserves are only required for demand deposits like checking accounts; time deposits require no reserves whatsoever.
When you tell this to sensible people, they stare at you like you come from another planet. Yet, this is not at all controversial among economists; it is simply the way we create money. In theory, the banks can create an infinite amount of money, so long as they can find solvent borrowers who are likely to pay it back. In such an environment, thrift is a paradox, because very little is needed to create credit; what is needed is borrowers, and borrowers need customers, and thrift cuts down the amount of consumption.
If this sounds nuts to you, it merely means that you are a sensible person, but not an economist or a banker. But alas, it is the way things are.