How the “Fundamental Monetary Constraint” affects a closed economy.
An important cause of periodic recessions and depressions in a closed economy using unexamined logic already well understood for international trade
What is the “Fundamental Monetary Constraint” and how can it negatively affect a closed economy?
This essay explains a number of known economic facts not obviously explained by contemporary macroeconomics. These consequences can be understood as the result of the effect of a surprisingly simple yet unrecognized basic property of money operating within a closed economy when a relatively fixed stock of money is used to exchange goods/services among producers and consumers. The argument is based on logic identical to what is already commonly known to analyze international trade.
1. Explains the following four characteristics that historically accompany recessions or depressions:
- Slowdown of GDP not explained by lack of ability to produce goods/services.
- Extra unsold goods for sale that have often been described as a “glut of unsold goods.”
- Unemployed workers.
- Reduced GDP often described by some as being caused by under consumption. Others describe the same phenomenon as over production.
2. Why economies are forced to “grow” even with stable population. Greater production efficiency in an economy likely does not lead to fewer workers or less total labor time–often at least as many are required as before–otherwise money will be lacking to consume the more efficiently produced goods.
3. Why total public and private debt virtually always must increase to provide money for consumption when economies are expanding..
4. Why any economy using money to exchange goods/services tends to lead to wealth inequality when some agents save money.
5. How trade imbalance within a closed economy happens and reduces GDP. That increases unemployment for the same reason that trade is reduced when international trade is imbalanced.
6. Trade imbalance in a closed economy stimulates loans and debt by creating new credit money that comes from extra money from “savers/exporters” and loaned to “dissavers//importers.”
The “fundamental monetary constraint” explains why…..
…nominal GDP must increase in an economy when productivity increases: As productivity increases within an economy, by definition fewer hours per worker are required for the same GDP output. Therefore some workers become redundant. In order to continue to purchase those goods/services the economy must find new jobs to provide income that will enable laid off workers to consume what they used to, plus the new goods/services provided from the new jobs that needed to be created. When productivity becomes more efficient “growth” in GDP must occur not because more goods/services are needed, but rather to maintain the income from workers that allows all goods to be distributed and consumed..
…Even in the best case where prices are reduced because of increased productivity for the more efficiently produced goods– jobs and new production output must increase to allow the redundant workers to continue to obtain income to participate in the economy.
… greater productivity in an economy will not decrease the number of people needed to be working in an economy: The economy may not need more stuff–but redundant workers must still find new jobs to have income to buy the same goods.
…an optimal amount of deficit national spending is usually necessary for an economy to maximize GDP. Too little reduces GDP; too much invites inflation.
It is well known that imbalance of international trade can over time force reduction of trade. This essay explains why a closed economy is similarly susceptible to the same imbalance that can cause recession or depression.
Recessions and depressions have periodically afflicted national economies for centuries. The claim of this essay is that possibly the most important cause for slowing a national economy and reduced GDP can be easily understood by analysis that is usually used only when analyzing the issue of “balance of trade” among different nations in an international economy. An “imbalance of trade” among nations with international trade is a well known cause for discouraging flow of such trade. This essay will show how a virtually identical issue of “balance of trade” among agents within one nation can similarly positively or negatively affect the flow of trade among individuals in a closed economy that results in recession or depression. As background I will start with a short discussion of international trade economics. Then next discuss an important similar but unexamined issue of trade imbalance that can occur within single closed economies that can result in recessions that reduce GDP, increase unemployment and produce excess unsold goods.
Within international trade it is well recognized that a country that imports more than it exports to other countries gradually experiences loss of reserves or “money” which historically could be gold, which gradually gets transferred to other countries that export more than they import. Over time, this gradually makes it difficult for the country that imports more to further import goods/services, because it gradually reduces their reserves or “money” or gold that the importing nation needs to purchase imported goods/services from other countries. At the same time exporting countries begin to lose customers when importers have insufficient money to purchase more goods/services from exporters. That is usually hardest on the importing country, but the exporting country also experiences a lack of demand for their exports that reduces their GDP. So both countries lose when this continues. What has been unnoticed or ignored from macroeconomics for a closed economy is that a virtually identical issue can occur in a single economy that can cause a recession or depression that reduces GDP.
Mercantilism: In the sixteenth to eighteenth centuries some countries had a policy of deliberately exporting more products/services than they imported, with the purpose of building up higher reserves of money, which would make it easier to enable them to import goods. This was called mercantilism, which especially in the seventeenth century was considered by many economists to be the best way to build wealth for a country. However, this policy caused the countries who were importing more than exporting to lose reserves, which would eventually shut them from the possibilities of importing from excess exporting countries. As this problem was better understood, mercantilism became out of fashion, and considered unworkable international trading policy, because it eventually began to discourage international trade for both exporting and importing countries, and in some cases increased conflict among nations.
I will explain how the “fundamental money constraint” is forcing the same mistake to occur within single economies. It is a likely common cause of past recessions/depressions–especially ones that cannot be explained by some difficulty in production. It also explains what is now being called by some in the present world economy “secular stagnation” similar to what was experienced in the 1930’s. It also explains the reason why both events were accompanied by high wealth inequality, and within a country could cause eventually result in class warfare or even civil revolutions such as experienced by France in the early 1800’s. .
How international traders attempt to resolve imbalance of trade: Institutions have historically developed for both international and domestic trade to facilitate transfer of money from “exporters” to “importers” to rebalance trade. I’ll begin with the international problem and describe how it is resolved, and after that discuss how a quite similar process can help resolve the problem for a closed economy using the “loanable funds” market.
The “fundamental monetary constraint” is the inherent property of money that applies to an economy that has a total fixed amount of money, and where all exchanges of goods/services are exchanged with money. Over an extended time period each agent is money constrained to consume no more money value of goods/services than he has earned from his past production of goods/services. It becomes a more serious problem in modern economies when some high producers produce much more value than they consume, which eventually constrains others to have less money than they need to allow consumption of the excess goods/services produced in the same economy by the high producers–quite equivalent to the problem caused by imbalanced international trade.. This forces a reduction in GDP. This essay will explain other institutions that have historically evolved to avoid the problem caused by this constraint that will allow goods/services to be better exchanged. The importance of this constraint has already been well recognized within international trade among nations.
How international traders attempt to resolve imbalance of trade: Institutions have historically developed for both international and domestic trade to facilitate transfer of money from “exporters” to “importers” to rebalance trade. I’ll begin with the international problem and describe how it is resolved, and after that discuss how a quite similar process that has already helped to at least partially resolve the problem for a closed economy using the “loanable funds” market.
One important way to resolve trade imbalance for international trade is for “exporting” countries to invest their extra funds in the “importing” countries—which has two desirable effects, at least from the point of view of economic theory: (1) Investment transfers money to the importing country which enables them to continue to buy products from an exporting country. (2) It also may allow importing countries to purchase capital for investment hopefully to enable them to improve their production capability and therefore achieve better trade balance.
However there is a possible disadvantage to the importing country—because for this benefit they must usually pay interest on the invested capital, which to be beneficial such investment must result in a greater longer term advantage than the disadvantage of paying interest cost. If improperly invested, it can result in less longer term wealth. That would be particularly destructive if the imported money were spent only for consumption goods from other exporting countries, for which there is not a future return. (The US is the unusual exception because the ease with which it can print money!) This same disadvantage can also occur in a closed economy.
One remedy possible with international trade is possible if the currency exchange value between two types of money is allowed to adjust between the two countries. Users of money of the net importing country can reduce the value of their money when they exchange it with money of the net exporting country, which will tend to equalize the value of trade between them. It is well worth noting that this advantage was eliminated when the Euro was adopted as the common currency for European nations. This has been regarded by many economists as being a weakness, or “mistake” that has caused difficulties making the Euro work as common currency to balance trade among many European countries. This puts different countries into one monetary straitjacket that disallows them from adjusting currency exchange rate to balance trade among countries. And of course this is not a method that could ever be used among citizens in one economy to resolve imbalances within that country, since everyone uses the same money.
It is remarkable that this problem has been so well recognized with respect to international trade, but completely unrecognized when considering a single closed economy. Individual agents in a single economy have a similar relationship among themselves as do “countries” with other countries with which they trade. Within a closed economy we can think of many individuals that trade among each other on a very small scale with each other with money exchange. Every individual will typically both “import” (purchase) and “export” (sell) products/service/labor with others inside their own economy. But for any individual it would be unusual for that person to purchase (“import”) exactly the same value that they sell in goods/labor (“export”) over some time, such as one year—which makes imbalance the most likely case. It is surprising to me that the economic importance and significance of trade imbalance between “importers” (net consumers) and “exporters” (net over producers) within a single closed economy has not been sufficiently recognized.
In part 1 of this analysis I will assume that all exchanges of goods/services are negotiated ONLY by exchange of money. I will show why that won’t work for a realistic economy. After that step 2 will introduce necessary additional methods that goods/services are exchange that are necessary to make an actual economy work..
How we can speak of individuals within one economy acting like “countries” in an international economy: Every agent must fall into one of two distinct categories:(1) those who are net exporters who produce more value of goods/services than they spend, and (2) the remaining who are “net importers” who produce less than they spend. If we take the value that one agent produces in goods/services/wages during one year, and subtract the value that same person spends in that year, we can define a net quantity for that person which describes how much more value they produced (“exported”), than they spent (“imported’) for one year. “Individual excess product” will be positive for exporters/savers in an economy and negative for importers/dissavers in the same economy. This is similar to “balance of trade,” among countries, but instead describes for each individual excess product with all the other individuals they trade goods/services within that closed economy. This number has the same significance for a closed economy as what in international trade is called a “current account,” which describes how much more value a nation exported compared with what was imported in a year. There will be one such number defined for every person in a domestic economy.
Another important number $C in a closed economy can be defined by adding up all of the net exporters’ accounts together, (=$C) which will result in a positive internal current account or total internal trade imbalance for all the “exporters” in the entire economy. If all agents trade using only money, the net importers, or dissavers also have a similar total internal trade imbalance which of course is a negative number (-$C). Making a simplified assumption that all trade is within one country using only exchange of a fixed total money supply, the dissavers’ negative number must be equal in magnitude to the savers’ positive number. So for both groups it is the same number, but one is positive and the other is negative. This is the total value of goods/services that need to be transferred from “exporters” to “importers” to achieve complete distribution of economic product within the closed economy. For the remainder I will describe the positive number as the “total internal trade imbalance.”
If money were the only means of distribution of goods/services within this economy this number would be equal to the amount of money ($C) that in one year that would need pass from “savers” to “dissavers” to distribute all goods/services. What hasn’t been said yet is that unless the total internal trade imbalance is exactly zero, meaning each person spends exactly what they earn, there needs to be enough previously saved money held by the “importers” to enable purchasing the extra goods they got from “exporters” without running out of money. Otherwise some goods will remain unsold because importers had insufficient money to pay for them. If there were not sufficient savings (“reserves”) possessed by “importers,” then to successfully exchange all goods there must exist some other means besides money to allow exchange all goods/services in a real economy when trade is unbalanced.
An important part of the subsequent analysis is to identify important additional mechanisms besides money exchange that have historically evolved to make more complete exchange of goods/services possible. If such additional economic mechanisms did not exist, there would be no way to get the extra goods/services from net exporters to net importers. The magnitude of the internal trade imbalance will determine how hard all such mechanisms must work together to allow maximum exchange of goods/services. Otherwise the exporters would get richer and richer and importers poorer and poorer.
To summarize, the “total internal trade imbalance” for a closed economy over one year is $C. If total money in an economy is fixed, and no other method of goods/service exchange exits, the total money saved by some must equal the amount dissaved by others. With fixed total money in an economy, saving money is a zero sum game just as is true for international trade. Saving by “exporters” equals “dissaving” by importers. We will then describe below some important other economic methods that have historically developed that (a) allow more opportunity in an economy for people to save and (b) allow the maximum goods/services produced within an economy to be well distributed to others. Oddly, these additional methods are not usually explicitly accounted for in conventional macroeconomics. In particular it will be vital to add a finance sector and also consider possible requirement for government deficit spending. These two methods have in practice evolved to make goods/services exchange work in a modern economy despite some trade imbalances. They need to specifically take into account of the quantity of total internal trade imbalance to judge how strongly they must respond to compensate. Only if a very unusual case of $C=0 will these not be necessary. The greater the value of $C for an economy, the more important will be other mechanisms besides exchange of money in an economy to allow distribution of goods to maximize GDP.
To distribute all goods the economy needs to transfer excess goods from “exporters” to “importers.” However the money importers need is in the hands of the exporters, not where it really needs to be with the importers. The exporters gained savings. If the “importers” and “exporters” switched sides frequently and randomly, together with enough money slack for saving, such as system might work. However, if the same people remained for years “importers” they would be in danger of running out of savings. This is the most fundamental process by which wealth inequality is born within an economy.
It should be evident that this could turn some citizens towards poverty over time, and others towards high cash wealth which shows how easily such an economy could have danger of developing towards early stubborn wealth inequality. It also demonstrates the necessity of a financial system that allows loaning money from “exporters” to “importers” to exchange goods/services. This is a possibly questionable service that the credit card industry provides.
Since it could have a strong effect on an economy, it should be seen why total internal trade imbalance is a number that should be an important one to measure and know, as well as being familiar with ways to counterbalance such imbalance. Even if its value is not known exactly it is still important to realize that such an important number exists—for the similar reason that “current account” is vital to know about when speaking of international trade.
Trade imbalance among agents within one economy can easily explain how historically repeatedly occurring “recessions” or “depressions” occur within a closed economy. Economists were frequently particularly puzzled by historical economic events marked by slowdowns in GDP that would happen for seemingly no obvious reason. What was so puzzling was that they occurred not with shortages of goods for sale. In fact these episodes were often accompanied by what were called “general gluts” of a wide variety of goods. These were mysterious events for economists because it was generally believed that economies could fail only if there were insufficient production of goods/services, not an excess. Often these events were described as an economy that would unexpectedly develop a lack of aggregate demand. Or such events were sometimes equivalently described as caused by “overproduction.” During such “recessions” there was desire for such goods from part of the population that had insufficient money to purchase them, which I’m suggesting were the “importers.” Interestingly, despite obvious recurrence of such actual economic events some economists said such events couldn’t possibly happen; because they didn’t fit their theory about how a capitalistic economy was supposed to work.
Here are four observed characteristics that were classical signs of recessions/depressions observed historically. They demonstrated that some portion of the population seemed to lack money required to purchase goods they wanted:
- Business would be observed to generally slow for no obvious reason.
- This was accompanied not by goods shortage, but by a “general glut” of unsold goods.
- Unemployment would increase because aggregate demand was weak.
- Not everyone found it difficult to buy goods. Some had plenty of cash for as much as they desired to purchase.
These symptoms are easily explained by the “Fundamental Monetary Constraint.” If a subset of people in the economy known as the “importers” ran short of money because of an overly large total internal trade imbalance over a period of time that made the extra goods unaffordable. The “exporters” had the money the “importers” needed to purchase such goods.
Trade imbalance can also explain how wealth inequality can start. Those who are the “importers” could gradually run low on savings. Thus GDP declines due to lack of demand. There is enough money, but money becomes poorly distributed within an economy to serve its main function of distributing goods/services to maintain GDP. The greater the value of trade imbalance $C per unit time in an economy the more rapidly money/wealth inequality has opportunity to develop within that economy.
Does mercantilism exist within a closed economy? Although mercantilism has been for two centuries understood as bad policy for international trade, the corresponding attitude in a closed domestic economy is usually exactly the opposite: the belief is expressed by economists and moralists that saving, by producing more than consuming, is highly praised, which leads only to virtuous outcomes, without understanding the negative consequence of the Fundamental Monetary Constraint that has been well recognized as a problem caused by imbalanced international trade. For some, belief in the undeniable virtue of saving was apparently more than enough reason to reject the logic being expressed in this essay.
The problem for our economy caused by the fundamental monetary constraint has increased since the 1980’s in the US because production equipment such as robots have taken the place of workers for much production work. Fewer people run the robots, reducing worker employment. Some people mistakenly believe that more college education is needed for redundant workers so a similar number of workers will be able to run the robots and will thus increase their income. But the whole point of the robots is to produce the same output with fewer people, which tends to increase the value of unbalance +C. Another recent cause is that much high labor intensive production has been moved out of the US where labor was cheaper, further decreasing number domestic workers having well paid jobs. So with lower labor cost, pay for management increases—while redundant and unemployed workers become in higher supply which reduces worker pay—increasing the economic imbalance +C.
“Lazy bums?” The methods to be listed below will be some that have been used to compensate for internal trade imbalance. If the economy does not provide sufficient compensation $C for imbalance, that requires some in the economy to dissave. Some in the economy who have wealth may think that those who don’t save must be “lazy bums.” Perhaps so, but if the compensation for $C imbalance is not sufficient in an economy, and the total quantity of money remains the same it will impossible for everyone to save. Perhaps blame the savers for saving too much. However bad macroeconomic policy, by not using more effectively some of the methods to compensate that will be described next, would likely be a more useful target for their criticism.
Some economic methods are listed below that have historically developed to compensate the imbalance . For each example below I’ve shown the numbers required to overcome an total internal trade imbalance of $C dollars. A policy objective to compensate for a trade imbalance of +$C could be achieved by using a combination of these methods where the total sum of all compensating factors needs to equal +$C dollars. If the compensating amount is less than that amount, aggregate demand could be weak. If more, that could increase aggregate demand beyond supply and risk over demand with possible inflation.
Method 1: Government taxes and spending for public services: An important purpose of taxes is to pay for needed public services that are more efficiently provided by a government single payer than would be practical to be provided by individual private funds. For accomplishing only this purpose it does not matter from which group: exporters or importers that such taxes are collected—or to where they are distributed; at best, political decisions about who to tax are made with some consideration of “fairness.” Or at worst, by considerations based on how much particular citizens promise to contribute to political campaigns.
However, government taxes can also simultaneously provide rebalance of trade in an economy to maximize distribution of goods/services. To serve this function taxes must come from “exporters” or savers that when spent on public products/services will be able to rebalance an accumulated total internal trade imbalance that will flow to importers. A problem for using only this method to completely rebalance an imbalance of $C, is that taxes must be collected from “exporters” in the same amount $C. To accomplish this task completely using no other method would be extremely unlikely because that would require a tax equal to the total of “savings” accumulated by all exporters which would then leave no money left for the “exporters” to keep as “savings.” Fortunately other methods exist using the loanable funds market and will be described that allow those providing revenue to also feel that they have been able to add to their savings. Taxing “importers” will usefully supply money to purchase public goods, but be of negative benefit to achieving trade balance since such tax will decrease importers’ ability to purchase goods needed to help achieve the objective of balancing trade.
One of the very worst tax policies possible is to reduce taxes on the wealthy, which would likely increase savings made by the “exporters” who even before they are taxed do not even purchase enough goods to make up for the excess they produce.
Method 2: Government transfer payments: Transfer payments that take money and transfer it directly to citizens is another effective means to accomplish rebalance. Three important methods in the US are Social Security, Medicare and Medicaid. The US payroll tax is unfortunately a regressive flat tax that is quite high at 15% on income that is taken from people with incomes from as low as $400/year to those with less income than $140,000/year, therefore a lot comes from importers, not exporters. That tax is immediately distributed to one of two places. (1)Most of the tax goes to Social Security and Medicare recipients—which likely places it in possession of recipients who spend it rather than save it, which would have a positive balancing effect . (2)The rest of it (if any is left) goes to purchase Treasury Bonds (via the S.S. Trust fund) that always immediately pay for government expenses. Therefore this sources money from many “importers” and some “exporters” and then it is spent for government expenses which compensate for some trade imbalance. The amount that this method can compensate for $C of imbalance is the total amount that is collected from exporters minus importers. As said before, any tax collected from “importers” reduces their ability to even compensate for what the importers have produced, so will negatively count as compensating for the trade imbalance. If the 14% tax were to be extended to all income above $140,000, including investment income, that would likely be more beneficial for reducing the $C number by placing this high tax on more likely “exporters” with high incomes, which could benefit the entire economy—both exporters and importers.
Method 3: Government spending by increasing public debt. Fiscal policy: Government can obtain revenue by selling Treasury Bonds which takes money mostly from “exporters” in the economy who want to save their money. It is spent on government operations which creates demand nearly dollar for dollar that will compensate for total internal trade imbalance. This is a beneficial method because the revenue comes mostly from “exporters” looking to save their cash money as “loanable funds.” Unlike the “government tax” described in method 1 above, this is a way of obtaining funds from “exporters” that allows them to feel like they are simultaneously keeping possession of their wealth as their ”savings” but saving in form of a Treasury bond earning interest instead of by holding cash.
But doesn’t this backfire later? It might seem that such bonds, when “paid back” at the end of the term would reverse the benefit just cited—which if that ever happened would be a serious defect with this method. That seeming drawback has been mostly successfully avoided by making Treasury debt always increase—so in effect the nominal debt amount never goes down, because there are always new purchasers of such debt seeking for a place for their “savings” that is sufficient to more than “roll over” Treasury debt that reaches the end it its term. So public debt virtually always increases. It is essentially a beneficial Ponzi process that that helps to counter the negative effect caused by the “Fundamental monetary constraint.” It is true that interest paid tends to go back to the “savers”, but even the interest paid has historically been attenuated by managing enough inflation in the economy to approximately match the interest, so it is borrowed at virtually zero real interest rate. The nominal total value of US debt has never gone down since at least 1955, (except for an extremely small amount in year 2000) so that using this method in practice means money becomes permanently transformed from cash “savings” from exporters back as spendable public cash money. An historical example from the UK that avoided the “backfire” of having to pay debt back were perpetual bonds, called “Consuls” that never needed to be paid back. Here is a graph showing such nominal public debt in the US since 1965. It shows that this method has soaked up over $25T of past cash since 1965 that has been converted by savers to non transactional money debt, never to be paid back. Method 4 is an identical process for which private debt has the same ability to reduce internal imbalance.https://fred.stlouisfed.org/series/GFDEBTN
Method 4: Exporters lend money to “importers” through “loanable funds market.” Method 3 above is actually a subset within this larger category 4. Method 3 described how public debt is a means of converting “cash” to a Treasury bond. An exporter purchases a bond which he holds as subsequent wealth—the money is spent for public spending. The same process can occur with a private bond, so the logic is the same, except the money is used for private instead of the public spending part of GDP. Or exporters can save their cash money with a bank savings account which will then be loaned to others to spend. This is the method that resembles what international trading countries often do to resolve their trade imbalance, by which an “exporting” country loans funds to an “importing” one. In the case of a closed economy, the “loanable fund market” within the country is used. In a closed economy money can both originate from one person who is “saving” and end up with another person who is spending into the same economy. Each dollar that is loaned to be spent compensates for one dollar of imbalance $C.
Method 5: Increase money flow from “exporters” to “importers” and goods/services flow from “importers” to “exporters.” One possibility to reduce imbalance is to develop businesses that hire unemployed “importers” to make goods/services to sell to “exporters.” Begin a new business manufacturing luxury pet rocks to reemploy them. Some newly hired workers can also be employed in advertising to persuade buyers of the great benefits of the new bling rocks product. The main purpose is not be to provide new needed products for the economy–its important economic purpose is to provide new income to increase aggregate demand. When production becomes more efficient, (higher productivity per hour) workers become redundant. This is why GDP must always grow. Not because more stuff is needed- the growth is necessary to simply maintain an ongoing fully employed economy. Another method that would be to reduce imbalance $C that would not need to increase or decrease GDP or production is to increase total pay to “importers.” For example, higher minimum wage. The fundamental monetary constraint implies that reducing pay to “exporters” and increasing pay to importers would maintain GDP but reduce economic imbalance and provide better distribution of goods/services.
“Loanable funds” are an essential way to allow people to “save money.” It is important to see the significant difference from holding an IOU for loaned funds and “holding actual money,” although either are considered a person’s “wealth.” As one person loans his money to another, the money is able to be re used, which is not possible when someone saves cash to hold or hoard for the future, which shows the advantage to an economy of saving by loanable funds, rather than cash. Beyond the scope of this essay is the further problem caused by accumulating debt resulting in massive wealth and poverty dispersion. This is a topic that has been well examined by Atif Mian and Amir Sufi in their 2015 book: House of Debt
The flip side the act of loaning is described by economist Richard Koo—When lots of loanable funds are paid back to the “exporters” rather than being loaned to “importers” this is essentially how what Richard Koo describes as a “balance sheet recession” causes an economy to go into a downturn—having the opposite effect as the loans had when they were being generated..
Loanable funds are likely to be in low supply if interest rate is too low: If interest rates are zero, there is no motivation for savers to choose loanable funds, as there would be no advantage to obtain interest over holding cash. Cash has the advantage of being held with zero credit risk, rather than being transferred to loanable funds that may have non zero credit risk, which shows how interest rates very near zero can slow, rather than stimulate an economy. The three reference graphs from the Fed below show how lower rates killed monetary velocity, showing that cash was held rather than used for transactions that generate GDP. When interest rates went virtually to zero far more cash money was held even as the Fed attempted to rapidly increase the money supply. As soon as the Fed generated more cash, this cash was held as “savings” because of the loss of any interest reward to loan it, keeping it from being used to stimulate GDP. However it did provide an actual economic experiment that invalidated Milton Friedman’s claim that monetary quantity was the only factor that has ever caused inflation. Particularly note in the US M1 Monetary velocity graph how rapidly velocity was reduced when interest rates went very low at 2008 and 2020.
US M1 Monetary supply: https://fred.stlouisfed.org/series/M1SL
US M1 Monetary velocity: https://fred.stlouisfed.org/series/M1V
US Ten Year Treasury interest rate; https://fred.stlouisfed.org/series/FEDFUNDS
The amount of M1 money supply limits the amount that can possibly be saved as M1 cash. In 2015 total M1 money supply was about $3T. Unlike holding M1 money as savings, there is no defined total limit for how much “loanable funds” can be created and saved. That number in 2015 was about $40T, but can rise as high as there are people confident and brave enough to loan to other borrowers. It’s beyond the scope of this essay to fully discuss the economic problem that such major wealth can cause—but it is obvious that the interest burden on the economy can rise which is a flow of interest money mostly from borrowers that are likely “importers” to savers that are “exporters.” This encourages wealth inequality to constantly rise.
Loanable Funds Debt is Exporters’ long term record of savings: This essay claims that total national loanable debt savings added in one year are what drive total public and private debt higher. The following graph of combined private and public debt shows that the sum of such debt has always constantly risen, which is why these methods are effective for rebalancing. The following link shows total US debt, public and private. Every year total debt increases by the amount of cash wealth that has been converted to loanable funds in that year. https://fred.stlouisfed.org/series/ASTDSL
There are (at least!) two possible reactions to seeing this graph:
- Most who believe they are the “responsible” economic commentators and even many economists that do not understand the implication of “The fundamental monetary constraint”: PUBLIC DEBT BAD!! WE’RE ON THE ROAD TO FINANCIAL RUIN! Three times US GDP!!
- Those who understand the implication of “The fundamental monetary constraint” can see this as a useful Ponzi scheme that has managed to last for over 70 years. It shows how savers “saved” wealth over years while that money simultaneously paid for $60T public goods and private investment. Savers as a whole never bothered or seemed to care about getting their cash back. Shows the benefit of inflation.
A question I have for economists: Isn’t a little out of date now to think that “scarcity” of goods/services is the main problem for economics to solve? Any trip to Walmart or Sears or Amazon since probably even the 1930’s should have dispelled that—except the period after Coved 19 which was a very unusual recent unfamiliar event causing slightly reduced supply.
But why has this problem been for centuries unrecognized for a closed economy?
A big question for me is “why hasn’t this internal trade imbalance problem with closed economies been recognized by economists—when it is now so well recognized in an international economy? Here are a few guesses: I suspect there has much embarrassment to economists to admit that “capitalism,” although it is exceptionally good at motivating production and high efficiency, isn’t so good at solving the distribution problem. One sad US statistic is that 50% of the US population holds 2% of the total US wealth. And 2% of population hold 50% of wealth. I believe one reason for this is economic policy neglect of consideration for better distribution which needs to accompany production. Many economists laud the efficiency and productivity of an economy, but quite neglect the equal importance for distribution. One immediate obvious problem if for an economy to susceptible to wealth inequality, which only recently has gotten more attention as it has recently gotten so extreme.