Home > Macro/Monetary Theory > It Turns Out They are Correct….. Sort of

It Turns Out They are Correct….. Sort of

I’ve been working on the implications of our monetary system and I have much more research to do but there is one thing which is becoming clear to me and it is very important.  Keynesians are actually correct that government spending is required to save the economy when we are in a liquidity trap.  To see this recall the following points already developed on this blog.

1.  M0ney is created as debt.  In order for more money to be created, the interest rate must be set below the natural rate (the rate which would occur in a free market) and the difference must not be offset by a decrease in the expected inflation rate.

2.  This means that the expected inflation rate must be higher than the rate which is compatible with the nominal interest rate in the long run.

3.  When money is created in this way, at any given time the amount of debt in the economy is larger than the amount of money (some assumptions go into this but this is approximately correct). 

4.  In order for the debt to be paid off when it comes due, money must be created in larger and larger quantities.

5.  In order for people’s inflation expectations to become true, the money supply must increase at an even faster rate. 

At this point the question is: what does it take to get people to keep borrowing more and more money.  I don’t think the answer to this is very clear theoretically but I do think it’s fairly clear that what we have actually observed is that this has required lower and lower interest rates.  When interest rates hit zero, we couldn’t induce enough borrowing to keep the money supply growing.  Once mony stops flowing into the economy fast enough to replace the money flowing out, prices have to fall.  At this point remember that there is not enough money in existence to pay off all of the debts.  This means the money that is out there will become extra valuable because whoever gets their hands on it will be spared and those who don’t will be foreclosed upon.  This means people will be anxious to trade real goods for this money.  This has the potential to cause a deflationary spiral from which few are spared since everyone is in debt. 

In order to prevent this deflationary spiral, money must be created somehow.  All money is created as debt.  People are unwilling to incur more debt.  So the only way to create more money is to force them to incur the debt.  But luckily, this is exactly what government does.  They spend money they don’t have and the debt gets placed on the collective.  No individual permission required.  So they are correct that deficit spending can hold off a collapse just by creating money and putting it out there.  We could bury it in the ground and let people dig it up as Keynes suggested. 

The reason this seems so counterintuitive to many people (myself included) is that it is contradictory to the basic laws of economics which would govern an economy which makes sense.  The reason it is correct is that we have created an economy which makes no sense!  We have destroyed the concept of money as it occurred in nature and replaced it with a system in which the survival of the economy depends on everyone sinking themselves deeper and deeper into debt.  In this system it is true that if we cut government spending we will have another downturn but that doesn’t mean that borrowing and spending more is the right thing to do.  We have been put in a tragic situation and told that there is only one way out.  But that way doesn’t lead to long-run stability and freedom.  That way only means that when the thing finally collapses, we will own nothing and the federal reserve will own practically everything.  (By the way, if you think you are safe because you have no debt, recall that the protection in the constitution from direct taxes has been gone since the Wilson years and consider to whom they will turn to try to pay down all the government debt they’ve incurred “saving” the economy)

For the record, I’m not sure that it is impossible to sustain an economy in this way.  I think it might be but even if it’s not impossible it’s still crazy to try, and it’s not working.  They created a system where they could bury us in debt and claim it is for our own good and we can’t argue.  What we can do is get rid of this system.

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  1. W. Knowlton
    August 12, 2010 at 7:20 pm

    An indebted person is not a person who is truly free. An indebted person (or people) must answer to someone else (the fed, the government). Collective goals can never be achieved unless the freedom of individual people is taken from them. I think that might be the purpose of this monetary system – to keep Americans in debt and not free. We pondered the unlikely thought that the problems with this system aren’t obvious to those in power. It must be known to them. I think it is and that someone is keeping this monetary system as a progressive tool.

  2. Free Radical
    August 13, 2010 at 6:38 pm

    Haha so I guess I’m accomplishing my goal of suggesting that without actually saying it. (=

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