This article about how the current behavior of the global financial system cannot be explained by "normal" models of economics or finance is an example of fallacy of composition in that it assumes what would be true for an individual is true for the economy as a whole. In this case it is not. GDP is a measure of what an economy produces in the course of a year. It is defined on a gross basis in that it does not account for depreciation of the existing asset base, but one can also look at it on a net of depreciation basis. Aggregate demand can exceed production to the extent that we import more than we export. But that is not what this author of the article was talking about. Each entity that produces either keeps what it produces as inventory or sells it. The resulting purchasing power can now be distributed to pay its employees, bondholders and shareholders or invested back in the entity in the form of investments in plant, equipment, etc. Those who were paid can then in turn can either consume, invest in their own entities, hoard currency, purchase existing or new physical assets or save using financial markets . Amounts saved as either debt or equity then provide the means for other entities to consume, purchase existing assets, make investments. It also can provide governments the financial means to engage in purchases or transfer payments. The recipients of transfer payments can then, consume, etc. Purchase of existing assets just exchanges assets some hold for purchasing power with which to purchase consumer goods, etc. or save via financial instruments (including equity). It switches ownership of goods such as housing but does not increase aggregate demand that allows for increased consumption and investment beyond what is produced (GDP) plus net imports. Looked at from a different perspective, the sale and purchase of an existing asset such as a house does not create any jobs beyond that of the middle men (realtors, etc.) whose contribution is included as part of GDP.

This is not to say that the distribution of ability to buy in excess of amounts earned is without any macro implications. In an economy with specialization we have to be able to produce something that someone else is willing to buy. Investments are made in order to be able to increase future production of consumer goods. Those investments include physical plant and equipment but also R&D, education and training (development of human capital), etc. For the most part in our modern economy the ability to put sheer labor to use it must be combined with capital that someone was willing and able to provide. When people are not able to find something to which they can apply their productive talents that someone else will buy they do not produce or consume except to the extent that someone or some entity is willing to help them out. When producers miscalculate where the future demand will be at prices that exceed costs of production (including necessary return on capital) certain physical capital and human capital will become wasted and those who invested in them will sustain losses. It also means that labor has to be redeployed. That may mean accepting lower payments as one's acquired skills are no longer valued or necessitate more human capital investment to be able to qualify for available jobs. Note that the return on human capital is dependent on the amount of time left in a working career and the premium over what their labor is worth without having that human capital. This makes it more difficult to redeploy older workers. When consumers go on a spending spree based on credit provided by savers they create more demand in industries that produce what they wish to consume. When they have to cut back capital and labor in those sectors will face lower demand and have to be reduced. When investors become more risk adverse because of bad experiences, etc. what happens is that some sectors will face higher risk premiums which may exceed the rates of return they can expect to earn or not be able to obtain capital at all. Those risk adverse investors will just drive the interest rate on low risk assets to very low levels. That can result in an economy in which government transfer payments increase resulting in higher taxes which will work to discourage even more investment and provide a place for risk adverse investors to place they savings in the form of more government debt issuance. That translates into a lower level of GDP. For an economy to maximize its prosperity one needs efficient capital markets that can move capital to where it is needed most, entrepreneurs and managers who correctly anticipate where profitable demand will be, the development of better technology and methods of production and distribution through research, trial and error, etc. and the willingness to accept innovation, flexibility in moving the means of production to where it can be used most efficiently, trust developed through ethics and culture reinforced by adequate legal systems and policing of crime, savers willing to take an appropriate degree of risk (that is prudent risk to allow innovation and new enterprise but without going into pure speculation), etc. It also requires providing the needed amount of transaction and near transaction means (i.e., money and near money) without causing a change in the overall price level (i.e., inflation or deflation).

Tyler McClellan comments:

What a magisterial post, such deep but sensible knowledge.

I think you might have gone slightly further however and elaborated how much of our economic activity does in point of fact depend on expectations of the future, the Keynesian convention of certainty, when none such exists.

I think your lay explanation of how expectations of the future affect both the demand to save and the demand to invest is very good. Hence the complex interest rate outcome. Much better than my own attempts at driving at this fundamental problem.





Speak your mind


Resources & Links