Friday, May 14, 2010
This post is encouraged by Edward Harrison’s post, which tries to make sense of some MMT principles. I’m also new to MMT’s idea of monetary value originally arising from the state’s accepting it as payment for tax, but in general, I think MMT principles are sound, and reflective of reality.
Think of a businessman and his business. The business is either generating positive net cash flow or negative. If positive, then it adds to the business’ existing stock of cash, and it is able to pay dividends to the businessman, thereby boosting his personal net worth. But if business expenses are greater than sales, then the negative cash flow depletes the business’ existing stock of cash. If the loss is that big, or persists for a long time, the businessman will have to boost its cash by injecting new shareholder funds. If he doesn’t, the business could eventually become insolvent, and the businessman loses his business.
Sometimes the business’ sales is going well, such that the businessman runs out of inventory. So he boosts inventory by buying more raw materials for production. But sometimes, the business needs more shareholder funds, so that it can pay for a sudden boost in business expenses, like rent, wages, or the utilities. (I’d also add that growing sales usually earns the business funds necessary to fund new raw material purchases, so the businessman more often than not ends up infusing new funds only when unplanned expenses crop up).
In the absence of new sales, adding raw materials only builds up more inventory. The company’s balance sheet may be getting bigger, but without new sales, this only leads to misallocated capital. It is important for the businessman to know whether a business issue can be solved by injecting new raw materials to increase inventory; or by infusing new funds, and to put those funds in exactly the place where he needs to put them. If they are continually misallocated, then the business will still end up needing more shareholder funds, and this could eventually bankrupt the businessman.
But the source of value should be clear. The businessman provides the initial value to the business, by seeding it with capital (without which there is no business). But if the correct conditions are present, i.e., right business plan, right market, right business resources, are in place, eventually the business creates its own value, by generating a positive return to the businessman.
Now think of the government and the economy. The economy is either positively growing, or undergoing a recession. If it's growing, then it's adding to its citizens’ existing stock of wealth, so they are able to pay their taxes to the government, thereby boosting state coffers. But if the economy is in a recession, then it is destroying existing businesses, and it needs to reallocate its resources to new opportunities. If the slowdown is that big, or could persist for a long time, the government will have to boost the economy by injecting new stimulus funds. If it doesn’t, the economic disruption could lead to a major depression/stagnation, as loss of animal spirits leads to more business destruction and greater debt deflation, thereby leading to a positive feedback of even more business destruction and greater debt deflation.
Sometimes the economy is going well, and demand is growing, so the economy needs more currency in circulation to settle transactions, otherwise some demand could be destroyed (discouraged). So government boosts the currency by loosening monetary policy. But sometimes, what the economy needs is more fiscal stimulus, like when private demand is stalled, so that its citizen’s businesses could continue generating sales, so they in turn can pay their basic expenses, like rent, wages, so that the situation does not lead to even more stalling of private demand. (I’d add that a growing economy by itself generates the credit necessary to settle growing transactions, so the government more often than not ends up needing only fiscal policy- if and only when private aggregate demand suddenly drops).
In the absence of sufficient aggregate demand, adding currency only builds up to more asset bubbles. Without new demand, this only leads to misallocated capital. It is important for the government to know whether an economic problem can be solved by injecting new currency, to facilitate more business settlements; or by infusing new stimulus funds, and to put those funds in exactly the place where the economy needs to put them. If they are continually misallocated, then the economy will still end up needing more stimulus funds, and this could eventually take its toll on the value of currency, or result in hyperinflation.
But the source of value should be clear. The state/government provides the initial value to the economy, by injecting money to the economy via various government expenditures (without which there is no circulating fiat that can be used by its citizens to settle transactions in a growing economy). But if the correct conditions are present, i.e., the right businessmen are starting the right businesses, a stable business environment is engendered, people are employed and adequately earning, eventually the economy creates its own value, by generating a healthy growing demand for goods and services.
That’s the analogy as I see it. This analogy, however, in no way indicates that I support the idea that government should micromanage the economy. What I am merely saying is that I see that government has a role to play - by providing the substitute demand when private demand is lacking. But it shouldn’t be telling its citizen businessmen what businesses to enter, or what rates of return particular businesses should have. Any more than a businessman can dictate what line of business will profit, what business plan will work, or how much money his business should earn him. In both the government and the businessman’s cases, the market decides these things for them.
Questions about Chartalism
Responses to my questions
On currencies, global trade imbalances,and the GDR
How to think of what's happening with the Euro
and the tongue-in-cheek US Banks are not capital-constrained
Posted by Rogue Economist at 6:38 PM