How the “Fundamental Monetary Constraint” affects a closed economy.
An important cause of periodic recessions/depressions in a closed economy using logic already well understood for international trade.
Ralph Hiesey, June 26, 2023
- Introduction: Summary of some negative economic consequences to be considered by this essay that are caused by Fundamental Monetary Constraint that can occur in a closed economy.
- International Trade Analysis: How trade imbalance has already been shown by economists to negatively affect international trade because of the Fundamental Monetary Constraint.
- What does it mean to have a trade imbalance in a closed economy?
- How a Closed Economy can fail because of the Fundamental Monetary Constraint similarly to the way international trade fails with trade imbalance if goods/services are exchanged only by money.
- Eight Additional Economic institutions which have historically evolved to help economies compensate for the problem caused by the Fundamental Monetary Constraint.
Section 1: Introduction: Summary of some negative economic consequences to be considered by this essay that are caused by Fundamental Monetary Constraint that can occur in a closed economy
Description of Fundamental Monetary Constraint: The way money works is pretty straightforward and quite well known. The Fundamental Monetary Constraint is easy to explain but whose negative consequence I believe has not usually sufficiently been considered in macroeconomic models. In a counterfactual simple economy in which all goods/services are allocated only by exchanging money, the Fundamental Monetary Constraint imposes the constraint that every agent is able to claim in the future the same money value in goods/services as that agent has earned in the past. The important constraint is that a money earner is rewarded with the same or less value as what he/she has previously produced. What you have earned is the maximum amount you can spend. The constraint means not more but could be less—if less is spent that will cause money to be saved or hoarded by the individual who has spent less than he/she earned.
That might seem a very reasonable, fair, and equitable goal—but there is something quite problematic and often overlooked about this constraint in modern economies in which there are some very efficient, possibly very highly capitalized producers who can often easily produce far more than they want to consume. The negative side is that if some are producing far more than they purchase, there must necessarily be others that produce much less in value than what they would like to purchase. In other words this is an excellent generator of both high and low income, and therefore an economic generator of income and wealth inequality. Perhaps it isn’t yet clear why when some who produce far more value, that fact must constrain others to provide much less. This will be carefully explained (mathematically!) in section 4 of this essay. This also implies that some produced inventory is not able to be purchased by those that have produced less, which means poor distribution of goods/services and reduces GDP for the entire economy.
This constraint would render an economy quite unworkable if in the US all goods were in fact only exchanged with money; fortunately we do not have that kind of ultra super “free market capitalism” with 100% goods/services “privatized.”.
The first part of this essay analyzes an extreme counterfactual economy in which no option is available for trading products except for using money. After describing serious distribution difficulties with that, I will describe a list of eight institutions that have historically developed which have tended to improve goods/services distribution, and have somewhat decreased the speed with which inequality could develop.
The intention of writing about this is to show how the “Fundamental Monetary Constraint” is the main constraint that has forced these eight institutions to come into being. Because of the possible negative consequence of “privatizing” all economic supply, there have evolved those eight institutions which I will describe in the last half of the essay in Section 5. At the same time, a strong motivation for writing this is to demonstrate that there is still much evidence that we still are being negatively affected by the “Monetary Constraint” and that more awareness is needed that would further improve the lack of distribution of goods/services, with accompanying income inequality that presently exists despite the benefit these compensating institutions provide. An important concern is to suggest that we need more of the compensating institutions—many of which some mistakenly believe are signs of extravagance and irresponsibility. I believe that at least one consequence of the analysis is to recognize that there is opportunity for a more ideal balance between “free market capitalism” and “socialism.”
The argument in Sections 2-4 of this essay is structured using logic identical to what is already commonly used to analyze international trade balance where trade among countries is imbalanced. The benefit is that it easily explains the following historically observed economic properties that have been exhibited by closed economies. The the essay is intended to show the following consequences of the Fundamental Monetary Constraint:
- Explains four characteristics that historically accompany many 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.”
Reduced GDP often described by some as being caused by under consumption. Others describe the same phenomenon as over production.
In addition–this essay supplies important logic to economists who need to understand and explain to the public and politicians:
- Why taxation must be concentrated on those with high savings to improve economy for everyone–not only because it seems more “fair.” Provides solid logic for why “trickle down” is such bad policy for everyone—even the rich—in an economy.
- Why deficit fiscal spending should not be considered reckless policy, but is likely almost always to benefit an economy (with guidelines for optimal amount). Explains the wisdom of deficit public spending which for good reason has now occurred in the US every year (except year 2000) since at least 1955. This logic is much clearer for me to understand than how many explain who are MMT promoters. Gives economist Keynes a better reason than invoking “lack of consumer confidence” to show more specifically what can cause the “low aggregate demand” that he realized could cause an economy to weaken.
- 4. Why government transfer payments, such as for Social Security and Medicare are not just “unfortunate government expense burdens that we cannot afford” but usually increase economic benefit and GDP when carefully spent and not done to excess.
- Why any economy using money to exchange goods/services tends to cause cash wealth inequality when some agents provide goods/services with much more money value than they consume. This is the first part of the inequality story. The second phase which further develops much worse inequality is well explained by Amir Sufi, Atif Mian and Ludwig Straub in these papers: “The Saving Glut of the Rich ” and “Indebted Demand” Quarterly Journal of Economics, November 2021.
Economists should consider that higher productivity can have an economic negative as well as positive effect: As productivity increases within an economy, by definition fewer hours per worker are required for the same GDP output. Therefore some workers become, as the British say, redundant. To maintain aggregate demand 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 for workers that allows all goods/services to be distributed and consumed. I would suggest that this would be an excellent topic for economists to analyze and try to find solutions to allow greater productivity without this bad consequence for distribution. Some institutions that have already evolved historically are listed in Section 5.
Section 2: International Trade Analysis: How trade imbalance has already been shown by economists to negatively affect international trade because of the Fundamental Monetary Constraint.
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 one neglected 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 is a well known cause for discouraging flow of such trade.
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 which 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 reason: imbalance can occur in a single economy that can cause a recession or depression that reduces GDP. In the closed economy case it is an imbalance between people who are net savers compared with those who are net dissavers.
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.
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 likely explains the reason why the 1930’s depression, and the economy after 2008 were accompanied by high wealth inequality. Happening within a country this could eventually result in class warfare or even civil revolutions such as experienced by France in the late 1700’s.
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 of the ease with which it can print money!) I will explain why his same disadvantage can also occur in a closed economy.
One remedy 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 within one economy to resolve imbalances within that country, since everyone uses the same money.
Section 3: What does it mean to have a trade imbalance in a closed economy?
It is remarkable that this problem has been so well recognized with respect to international trade, but completely overlooked when considering just one (possibly 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 only 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. It is important to the analysis to see that just as in the international case, within a closed economy the increase of money gained by the savers is exactly equal to the decrease of money to net dissavers.
In the following section I will assume that all exchanges of goods/services are negotiated ONLY by exchange of money although no modern useful economy could completely impose that strict condition. I will show why that won’t work for a realistic economy, especially where some agents produce much more than they consume. Goods/services may not be well distributed within the economy. Later Section 5 will introduce necessary additional methods that have historically developed that allow some goods/services to be distributed that are necessary to allow an actual economy to work without direct exchange of money.
How we can speak of individuals within one economy acting like “countries” in an international economy: When money is the only means of trading goods/services, every person in a closed economy 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 value than they purchase. 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 the excess product with all the other individuals with whom he/she trades 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” together in the entire economy. If all agents trade using only money in a closed economy, the net importers, or dissavers also have a similar total internal trade imbalance which of course is a negative number (-$C). Because of how money is used as explained in the description of the Fundamental Monetary Constraint on page 2, 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 without having the “importers” run down their savings. For the remainder I will describe the positive number as the “total internal trade imbalance.”
If $C is zero, that would be the simplest –in the sense that every single person would have purchased in value exactly what he/she earned, with no one having either saved or dissaved. (Of course this doesn’t mean everyone’s amount earned was the same.) But if ($C) is positive, then all the exporters (savers) would have produced a total of ($C) more in value of goods/services than they consumed. Where did those extra ($C) goods/services go? They went to the importers (dissavers) who would have spent a value exactly ($C) more, which must have come from money the dissavers had previously saved. This would be no problem for the net positive savers, but there is the possibility that some of the dissavers could have run out of money–and not been able to purchase all the goods/services they wanted–which if that happened could be bad not only for them, but also for some of the net savers who might have been left with extra inventory they didn’t sell.
Section 4: How a Closed Economy can fail because of the Fundamental Monetary Constraint similarly to the way international trade fails with trade imbalance if goods/services are exchanged only by money.
SUMMARY: For hundreds of years it has been known that countries that have an imbalance of trade in goods/services (without compensating investment exchange) will develop an imbalance of money–the net exporting country will gain money wealth exactly equal to what the net importer loses. The greater the trade imbalance, the more rapidly will that happen. What surprisingly seems not to be understood today, and what this analysis shows is that exactly the same thing happens among single agents in a closed economy, when an imbalance of goods are exchanged with money. Just like the international case: The “exporters” that sell more than they buy get richer. And simultaneously the “importers” that buy more than they sell get poorer by exactly the same amount as the rich get richer. And the greater the value of imbalance ($C) per unit time the faster it will happen. The Fundamental Monetary Constraint constrains the average total amount all agents can hold is zero.
Some may question that last sentence, because as everyone knows, total money in an economy changes–however the only people who can increase or decrease total cash in an economy are bankers. The Monetary Constraint is true when including only people and cash used to buy or sell goods/services. Some may think credit is like money–true–but credit granted and received always nets to zero.)
The analysis so far has assumed that only money exchange is used to exchange goods/services. But fortunately there are other economic institutions that have developed that can make things better. In Section 5 I will describe additional mechanisms besides money exchange that have historically evolved to compensate for such imbalance.
Since total internal trade imbalance could have a strong effect on an economy, it should be seen why it is a number that should be an important one to measure (by the Fed) 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 easily explains one cause for 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 seemingly for 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, who I’m suggesting were the “importers.” Interestingly, despite the 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. Also, sometimes people called “supply siders” will mistakenly insist that what is needed is more supply, or even tax cuts to the rich, rather than seeing that the problem is caused by there being some in the economy who lack sufficient income to purchase the supply that is already available.
Here are four observed characteristics that are classical signs of recessions/depressions observed historically that were formerly difficult to explain. 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.
They were 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, the extra goods became unaffordable. The “exporters” had possession of the money that the “importers” needed to purchase such goods.
But it is true that economist Keynes already explained why recessions happen and how to fix them. His explanation was that such recessions/depressions were caused by “reduced aggregate demand” in an economy–an explanation perfectly good for predicting the recession attributes I cited. Keynes’ only explanation for this reduced demand was that there was a reduction in “consumer confidence” for which he apparently had no other explanation. I’m suggesting that the failure of “consumer confidence” could be explained by my hypothesis that gradual poor balance of trade between “exporters” and “importers” had caused low confidence for the subset of “importers” simply because they began to run low on spendable money which had been transferred to “exporters.” “Low confidence” likely did not occur for all consumers, but mainly with the subset who were the “importers” in the economy–some of those who may have been unemployed for a while because of the imbalance of trade. This hypothesis could be proven or disproven if we had real time information about trade imbalance ($C) within a country. It suggests that recessions/depressions could be predicted by an increase over time of a trade imbalance ($C). Another reason to prefer this view is that “consumer confidence,” according to the Investopedia website, has been more commonly observed as a lagging indicator of unemployment, suggesting that it is likely to have been caused by some earlier event– which could be caused by an ongoing trade imbalance. To my knowledge, the Fed does not try to measure this–but they get close by their (recent) measurements of Distributional Financial Accounts of wealth. Possibly all they need to do is add to this very useful data is to include income values for their four wealth categories (0-50%, 50-90%, 90-99%, 99-100%).
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 as a spur to investment has been apparently more than enough reason to reject the logic being expressed in this essay. An example: British economist John Hobson, who expressed a view similar to what is expressed in this essay, found strong opposition from economists to his thesis that excessive saving could result in reduced economic performance. Near the end of his life in 1938 he wrote his final book with the wry title “Confessions of an Economic Heretic.” My personal confession is that knowing his fate I have avoided saying there is a problem with “too much saving”–but it is true that another way to describe those who consume much less than they produce is to use the “s” word: savers.
“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 for an imbalance of $C, 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, it will be 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 described below, would likely be a more useful target for their criticism.
Problem for our economy: Robots: 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 using the robots is to produce the same output with fewer people, tending to increase profit per worker, which tends to increase the value of unbalance +C. Production engineers help to produce goods more efficiently, often meaning using fewer people to produce the same output, increasing internal economic trade imbalance. Macroeconomists frequently tout “higher productivity” without understanding its possible negative effect on income distribution. Walmart and Amazon are recent real life contemporary examples.
Problem for our economy: Shifting to cheaper production labor in China and Mexico. Another recent cause is that much high labor intensive production has been moved out of the US to reduce labor cost, which further decreases the number of 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.
Section 5: Eight Additional Economic institutions which have historically evolved to help economies compensate for the problem caused by the Fundamental Monetary Constraint.
Here is a list of economic methods that have historically developed to compensate the imbalance. For each example below I’ve shown the numbers required to overcome a 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 whom 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, the other function emphasized in this essay is that government taxes can usefully also provide rebalance of trade in an economy to maximize distribution of goods/services. To serve this purpose 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 allow 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 total 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 that will be described, using the loanable funds market that enable “exporters” to add to their savings that earn interest. 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 Increase pay of “importers” An example could be laws that establish higher minimum rates of pay, which would benefit almost always non savers. The total amount of additional pay in the economy gained by importers would reduce $C by that amount of additional pay.
Method 3: 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 15.3% 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 gets transferred to recipients who spend it rather than save it, which would have a positive balancing effect. (2)The rest of the tax (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 15% 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 4: Government spending by increasing public debt. Fiscal policy: Government can obtain revenue by selling Treasury Bonds mostly to “exporters” in the economy who want to save. The money 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 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 (nominal) Treasury debt always increase—so in effect the 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 of its term. 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 beneficial Ponzi scheme in practice permanently transforms cash “savings” from exporters back as spendable public public cash money. But the total amount borrowed has gone up for 60 years, and being over 100% of GDP cannot ever realistically be paid back which makes it close to a Ponzi scheme. However in this case it is completely for public benefit, and where no one is ever likely to complain about not getting their money back–because the Fed can print the money–although there is no guarantee that those dollars will be worth as much.
But what about interest on public debt? It is true that interest paid tends to go back to the “savers”, which would make this “Method 4” less effective. 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. This has been described by some as “financial repression.”
Is financial repression a good thing? “Financial repression” has been the denigrating label that has been used to describe government policy to keep government bond real interest rates low. According to the website “Investopedia”:
“The [financial repression] concept concept was first introduced in 1973 by Stanford economists Edward S. Shaw and Ronald I. McKinnon to disparage government policies that suppressed economic growth in emerging markets……..A government steals growth from the economy with subtle tools like zero interest rates and inflationary policies to knock down its own debts.”
However the analysis in this essay shows how this so called “repression” benefits an economy by reducing interest rates on government debt. It takes no difficult economic analysis to see that such policy reduces the flow of money from Treasury bond interest paid by less wealthy taxpayers to the more wealthy individuals who can afford to buy Treasury bonds. Contrary to claims that it “steals growth,” if such interest savings are used to reduce taxes mainly to “importers” it allows them to increase their after tax income, without reducing government expenditures, resulting in increased GDP. Here is a graph showing nominal public debt in the US since 1965. It shows that this method has soaked up over $25T of past cash savings since 1965 that has been converted by savers to non transactional Treasury debt, never to be paid back. Method 5 is an identical process for which private debt has the same ability to reduce internal imbalance. https://fred.stlouisfed.org/series/GFDEBTN
Why perpetual bonds are useful: An historical example from the UK that avoided the “backfire” of having to pay debt back were perpetual bonds, called “Consols” that never needed to be paid back.
Method 5: Financial markets historically developed that allowed exporters to lend money to “importers” through credit, such as “loanable funds market.” Exporters likely have extra money. Importers lack it. So it is useful, and not surprising to see how a market for credit naturally gets created caused by an economic imbalance—with exporters wanting to loan to importers. Thus Method 4 above is actually a subset within this larger category Method 5. Method 4 described how public debt is a means of converting “cash” to a form of credit, called a Treasury bond. Similarly, financial markets, such as banks and bonds developed so that an exporter can “save” or “loan” money to a bank—which is an asset he/she holds as subsequent wealth—The logic is the same as for public bonds, 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 becoming credit 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 spends into the same economy. Each dollar that is loaned to be spent compensates for one dollar of imbalance $C.
The general term “Loanable funds” is an essential way to allow people to save far more massive amounts of money than would be possible if cash money were the only method of saving. It is important to see the significant difference from holding an IOU for loaned funds and “holding actual money,” although either can be 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. In this manner, very limited savings of “basic cash” has been converted over time to a huge pile of interest paying public and private bonds that essentially never gets paid back. The FRED graph on their website—“All sectors; Debt securities and loans” shows total public and private debt in the US from the 1950’s to the present: In 1950 it had nominal value of $389B but now is equal to $90T, virtually for all recent time a monotonically rising number. https://fred.stlouisfed.org/series/TCMDO
This immense total could be viewed as a record of accumulated past savings that have been converted over seventy years’ saving of cash, never having been returned, now fossilized unto to a huge pile of bonds and other means of paper debt that represent in value nothing more tangible than a promise to pay money eventually—that is way too huge to actually ever be “paid back.” It burdens taxpayers with interest expense which represents an income stream from those of low wealth to others of high wealth. Just one recent book about the problem caused by such immense debt has been written by economists Amir Sufi and Atif Mian in 2014 entitled “House of Debt.”
The flip side of the act of loaning is described by economist Richard Koo—When high amounts of loanable funds are paid back to the “exporters,” this reverses the loan process, and is what Richard Koo describes as causing a “balance sheet recession” which causes an economy to go into a downturn—having the opposite effect as the loans had when they were being generated.
If interest rates are too high, it is usually assumed that loanable funds are likely to be in low demand, slowing an economy. However if interest rates are too low, they are then likely to be in low supply: If interest rates are zero, there is no motivation for savers to loan funds. Those with cash may then want to hold money with zero credit risk, rather than holding loanable funds. This demonstrates how interest rates very near zero can slow an economy, causing what Keynes called a “liquidity trap,” or which I would describe as money with low monetary velocity, which would tend to reduce aggregate demand. This may have been what happened to slow the economy in the 1930’s. 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 being 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 these graphs what happened when interest rates changed 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 borrowers who can be trusted not to default. 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” borrowing from savers that are “exporters.” This encourages wealth inequality to constantly rise. The problem that this debt causes is well explained by Amir Sufi, Atif Mian and Ludwig Straub in these papers: “The Saving Glut of the Rich” and “Indebted demand“. Quarterly Journal of Economics, November 2021.
Method 6: Increase GDP by increasing production of new goods/services targeted to exporters. Create new jobs to produce new products/services to sell to “exporters” that can maintain GDP by moving money from “exporters” to “importers.” This is why economic “growth” is necessary for an economy. It is not because the economy has need for more stuff. Production of more stuff is necessary to provide jobs, and thus generate spending money for the redundant workers so they can continue to purchase what they were spending before, plus the new output they are producing with their new jobs.
Method 7: Persons default on credit debt: Default on debt amount of $D will decrease imbalance by the amount $D. However, if the creditor is judged “too big to fail,” the Fed may decide to print money for the default amount for the creditor. This will improve the monetary wealth of the creditor by $D. The amount of “credit” will be converted to “cash” which will increase the money supply by the amount of the default.
Method 8: Agents can give gifts of products/services to others: For example several agents can combine into one family to act as one agent. One family member earning sufficient money can distribute goods/services to support others in the family. Charities funded by people who earn enough income can provide necessary products/services to others who can not afford to pay.
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. Every year total debt increases by the amount of cash wealth that has been converted to loanable funds in that year. The following link shows total US debt, public and private. 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!! $30T we need to pay back! $100,000 for every person–man, woman child in America!
But a second, I would claim even more responsible view: virtually none has EVER been paid back. The only time was a very small amount during the Clinton administration–which just convinced President GWB that there was extra spending money that could allow him to give a tax cut to the wealthy–which immediately made the public debt resume its customary and necessary increase. 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 has distributed an extra $30T of public goods–while likely increasing GDP by $30T over 70 years. It shows how savers have felt that they have “saved” wealth in the form of Treasury Bonds over years while that money simultaneously paid for $30T public goods/services. Savers as a whole never bothered or seemed to care about getting their cash back. People, similar to Trump, seem to feel pride about how high their wealth is–which is so much that they apparently have had no need or desire to spend faster than others decided to purchase new Treasuries. It has been a method of successfully distributing public goods/services that have been produced by individuals who have produced much more than they consume–meaning more than they needed to spend–which otherwise would not have allowed goods/services able to be distributed–thus increasing over time $30T more total GDP.
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.