Home > Macro/Monetary Theory, Uncategorized > Economics Having Nothing to do with Broken Windows

Economics Having Nothing to do with Broken Windows

Finally, the much-anticipated followup to the wildly popular and controversial “Still More Broken Window Economics.”  For those of you just joining us we find ourselves on an island with one really rich guy who owns all of the means of production except for labor which is owned by a group of peasants.  By assumption there is productive work that the peasants could be doing but they require use of the rich guy’s productive resources in order to do it.  The question is why wouldn’t they be able to come to some mutually beneficial arrangement with the rich guy where they work his land and they split the produce somehow?  And in particular, how can this reason be overcome by a hurricane hitting the island and destroying the rich guy’s stuff?  (To avoid the monopsony problem, going forward I will assume there are several landowners.)

When exchange takes place in real goods (this would include commodity money) in a free market (so without all the things I listed in the last post) there is no reason to think that this would be the case, at least not on a large scale.  Obviously transaction costs aren’t zero and this means you wouldn’t necessarily get the most efficient outcome in every situation but I am quite confident you wouldn’t have a situation like the one described.

The problem stems from the monetary and banking system and to fully understand the problem you have to start from the beginning of said system rather than just look at the downturn.  So take our island economy and imagine it is in a condition of free markets, property rights and commodity money and that the workers are employed at the efficient level.  This means that the marginal cost to them of their labor is just equal to the wage which is equal to their marginal product.

In addition to the efficient allocation of labor, there is also an efficient allocation of consumption and investment over time which is brought about by market interest  (both real and nominal) and inflation rates.

Enter the central bank.  The bank goes to the landowners and says “hey landowner, I can loan you money at a nominal rate lower than what currently prevails in the market.” If the landowner is not too economically sophisticated he will say “cool, in that case I will borrow more and invest more.”  If he is particularly sophisticated he will say “ok, but are you offering that rate to everyone and supplying the funds by just printing more money?  Because if you are, then it will just drive up prices in the short run (inflation) and then drive them down in the long run when people have to pay you back (deflation) so the real rate won’t change and I should invest the same amount, but since this is going to drive prices up I will have to borrow a little more in order to do it.”

If everyone said the second thing, there would be no problem just some inflation and then some deflation and all real variables would remain unchanged.  However, the banker doesn’t allow this, he says “don’t worry I know how to control inflation and I will keep it steady and positive.”  So the landowners say “low rates and high inflation huh?  Ok I’ll take a big loan and invest it and hire some more workers.”  This drives wages and the price of capital up.

Meanwhile, the banker goes to the workers and says “hey workers, I can lend you money at a rate below the current market rate.”  And if they were relatively unsophisticated they would say “great, I will cut back on my savings and/or borrow more and use it to buy more consumption.”  If they were very economically sophisticated they would say “ok but since you’re doing that for everyone, it’s just going to drive prices of consumption goods up now and then down in the future when the loans have to be paid back so I will consume the same amount but I will need to borrow a little more (or save a little less) in order to pay the higher prices for consumption today.”

Of course in the latter case, the banker will say “don’t worry I know how to control inflation and I will keep it steady and positive.”  So the workers say “great, low rates and high inflation and my wage is rising!  I’m gonna borrow more/save less and consume more.  Naturally this raises the price of consumption goods.

So for a while this goes on, prices of everything go up and everyone feels good.  But in a little while people stop borrowing and start paying back loans.  They figured this would be no problem because they figured prices would keep rising.  But since everyone is in basically the same situation they are all trying to pay loans back and not borrowing and this threatens to decrease the money supply which starts putting downward pressure on prices.  If prices fall, the people won’t be able to pay back their loans.  But the banker has a plan.  He offers them even lower interest rates.  And since, again, he promises to keep prices rising, they put off payment of their loans in favor of borrowing even more.  This causes prices to continue to rise fulfilling the earlier promise of inflation.

This goes on for a while but eventually nominal rates hit zero (or very close) and they cannot continue this strategy.  At this point, the money supply starts to fall.  What’s more, it is falling to a point lower than the original (commodity) money supply because all the loans that have taken place were made with interest.  Now everybody is trying to get their hands on some of the shrinking money supply in order to pay back their loans and save their collateral.  The land owners now are not thinking about what could be produced on their land and trading a portion of it for the other resources they need (like labor).  They are thinking about getting some cash to save their land.  If they could produce and sell the produce and get enough to do this they would but there is a problem.  The peasants also have debts which means they are also trying to get their hands on cash to save their stuff which means they are not very willing to pay for the produce of the land owners, they just want to work to get money to pay off their loans.  This means that the landowners can’t profitably employ them because it is no longer about producing real goods, it is about getting money to pay off loans.  Since nobody is willing to buy their produce, the best they can do is shut down (or at least cut back) production and try to hold on to as much of their cash as they can.  In other words you get low interest rates, low inflation, and high unemployment.  Sound familiar?

I know there are some questions that this doesn’t quite answer.  If I had the answers I would be publishing it in the AER not in a third-rate blog.  But hopefully this will get/keep the discussion going so feel free to ask them anyway and maybe we will find the answers.

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  1. September 20, 2011 at 4:41 am

    So, who exactly are they repaying their loans too? Central banks? And in our case, we are borrowing a lot of money from abroad, so how would that change the dynamic since it’s not really an “island”?

  2. Free Radical
    September 20, 2011 at 6:33 pm

    Yes they repay the banker. When they repay the central bank the money is either “destroyed” or used to buy something else. Usually the something else is more financial assets which means it’s essentially loaned out again. If this isn’t possible and they want to put the money back out there they have to buy something else. Theoretically they could buy anything they want but that story ends the same way (with the bankers owning everything).

    • J Thomas
      March 4, 2014 at 4:09 am

      “For those of you just joining us we find ourselves on an island with one really rich guy who owns all of the means of production except for labor which is owned by a group of peasants. By assumption there is productive work that the peasants could be doing but they require use of the rich guy’s productive resources in order to do it.”

      ….

      “Theoretically they could buy anything they want but that story ends the same way (with the bankers owning everything).”

      So we end up with one rich banker who owns all the means of production except for labor which is owned by a bunch of peasants and former landowners. The banker can decide how much of his land etc to use to produce stuff.

      He wants to produce enough stuff for himself to live a life of reasonable luxury. And he also has to produce enough stuff for the peasants who will produce stuff for him. If he can’t get enough peasants to work for him then he has to do everything himself. So enough for luxury for himself and at least subsistence for his employees. Say that to do this he must employ 40% of the peasants. What should he do about the rest? Well, he might want to pay 10% of the peasants to build weapons to arm another 10%, so they can make sure the remaining 40% don’t cause too much trouble before they starve out….

      Or maybe he could let the remaining 60% use his surplus land and means-of-production to make enough stuff for themselves. But that isn’t efficient for him. Unless he wants more stuff for himself than he can get from the first 40%.

      Maybe a religious leader will tell him to build a pyramid….

  3. September 20, 2011 at 10:29 pm

    That’s a nice sentiment. That’s how I thought this all ended.

  1. December 20, 2011 at 2:37 am

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