Sunday, July 22, 2007

Weekend Contemplation #2 – Wealth vs. Money

Another article with thinking over, from the WSJ:

The main fallacy in monetary theory and policy is the confusion of money and wealth. Money is wealth from the individual perspective since individuals can usually exchange it for goods and services. Money -- and financial assets easily converted to money -- may not be wealth for society as a whole if the production of goods and services has not kept pace with claims on it. Early spenders may have some success, but inflation will dilute the buying power of others. The bottom line is that real wealth has to be produced; it can't be printed.

Don't call me a Keynesian, but Keynes's Paradox of Thrift is another example of the fallacy of composition -- what's true for the individual may not be true for the group. Most U.S. families should be saving more. Indeed, the personal saving rate -- the percentage of disposable income not spent on consumption -- hovers around zero, with frequent dips into negative territory. This is made possible, for a while, by selling assets, accumulating debt, or spending capital gains in the housing and stock markets. Money obtained by realizing capital gains spends as well as money earned on the job. But not if too many of us try it at once.

The Paradox of Thrift says that attempts to save more in the aggregate reduce consumption spending, which, if not offset by increases in other spending, will reduce total spending and income. The paradox comes in when attempts to save more results in reduced saving out of lower incomes. The irony is that policy makers advise more saving but those who take the advice will benefit only if most of us ignore it, and policy makers are implicitly counting on that outcome.

A parallel is the farmer who hopes for a good crop year. But, if all or most farmers have a good crop year, the decline in prices may more than offset higher yields. What our farmer really needs is a good crop in a bad crop year. Then he could look for a popular restaurant that isn't crowded.
I realize this is not very sophisticated stuff, but it's on my mind because of the many talking heads I hear dismissing the adverse consequences of our low personal saving rate by saying it ignores capital gains as a source of spending. "Properly measured," they say, saving is not a problem.
Again, that may be true for the few, but not for the many. A penny saved may be a penny earned, but it matters whether it was earned by producing more or by a rise in the price of existing financial assets. A stock or housing market boom creates apparent wealth in the form of capital gains, but trying to convert it to real wealth en masse can make it disappear.

Economists say the main reason they worry about the budget deficit or the current account deficit is their impact on domestic saving. But my guess is that only other economists really get their meaning. Most people may be even further misled by the implication they hear that since the main harm of deficits is their impact on saving, they must not be too harmful after all. The old-fashioned notion that deficits are bad because they create debt that must be paid back with interest is probably a better prod to constructive behavior. Or that deficits impose a burden on our children or grandchildren.

Alan Greenspan has been one of the few economists to explain these matters correctly and -- I can't believe I'm saying this -- understandably, usually in the context of Social Security or other entitlement reforms. Whenever confronted by various financial fixes during congressional testimony, he frequently pointed out that any solution to the problem had to include real economic growth. With claims on output growing rapidly, output has to grow equally rapidly, or the claims are bogus. Any solution to our entitlement problems must include a bigger, more productive economy in the future. It's really as simple as not selling more tickets to the Super Bowl than there are -- or will be -- seats in the stadium. Of course, the political preoccupation with distribution rather than production puts unnecessary limits on the size of the economy on Super Bowl day.

The problem goes beyond government entitlement programs. Consider the baby boomers whose IRAs, 401(k)s and personal investments helped drive the stock market to record highs. What happens when cash-in time comes? There will be a mountain of paper claims on output, but will there be an equally tall mountain of output?

The great French economist, Frederic Bastiat, said that "The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else." It's time to get real about producing real wealth, not just financial claims on wealth.

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