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Why is There So Much Confusion in Macroeconomics?

by Frank Hollenbeck, Mises:

Should we print, not print? Stimulate, not stimulate? Is austerity the right or wrong policy? Is government spending or printing effective? If we ask two economists these questions, we will likely get three opinions for each question. Economists seem confused, yet these questions are more important today than ever. Where does this confusion come from? Doesn’t economic theory give us clear-cut answers? It does, but poor terminology and a lack of focus have muddied the waters. Many macroeconomic disagreements can be elucidated with a better understanding of the role played by holding cash, or hoarding, in economics.

To a large degree, Keynes is to blame for much of this confusion by using a double entendre. In his “General Theory,” he did not clearly distinguish between savings (correctly defined) and hoarding. The paradox of thrift is a misnomer. Thrift is both savings and hoarding. It should correctly be called the “paradox of hoarding”. Economists should not be this careless with terminology.

Even today, confusion persists. When Paul Krugman discusses thrift he is alluding to the impact of hoarding. When Austrians talk of thrift they are referring to savings. Keynesians and Austrians seem to be on different planets and some of the blame can be attributed to poor terminology.

In a circular flow economy, the value of output must be equal to income. Income represents claims on goods and services, and can be divided into three categories. It can be consumed, saved or hoarded. Consumption is using claims on goods and services for personal satisfaction. The correct narrow definition of savings is a transfer of claims from one group to another. This is the definition found in the classical loanable funds theory of interest rates. The saver is giving up his claims to be able to consume more goods and services in the future. He makes this transfer to investors who use these claims to purchase plants and equipment to produce goods and services in the future. The last category is hoarding, or holding cash, which is the equivalent of stuffing money in your mattress. From income, it is the only claim that is not used to purchase currently produced goods and services. Keynes, and his followers, constantly uses the word “savings” to imply two very different and distinct acts: the activity of transferring claims and the activity of holding claims. Classical economists were never this careless.

Since these claims are unused, Keynesians fear, in a circular flow economy, the value of output would be higher than the amount of claims used to purchase that output. Since some output would remain unsold, inventories would rise, output would be curtailed, and a downward spiral in output would ensue. Any future shift in hoarding will create another spiral in output. In this scenario, prices do not fall to bring the value of output in line with the value of claims. In a Keynesian framework, prices are sticky downward.

Let me explain this point with a very uncomplicated example. Suppose you have 10 pencils and $10. What is the price of a pencil? It can’t be $2 since we would have pencils that remain unsold, so the price would tend to fall. It can’t be 50 cents since people would have money and nothing to buy. Prices would be bid up. This would lead to equilibrium where pencils would be sold for $1 each.

Since the government does not create pencils, the only way it can obtain pencils is by taking claims from others by borrowing, taxing or printing. If it prints $10 and used it to buy pencils, the price of pencils will increase to $2 (inflation) since we now have $20 chasing 10 pencils. The government will obtain 5 pencils by lowering the purchasing power of money. It has taxed cash balances the equivalent of 5 pencils. The same logic applies to taxes or borrowing. Every dollar printed, borrowed or taxed to finance government spending displaces an equivalent purchasing power from private consumption or investment spending. Government spending is robbing Peter to pay Paul. It rearranges the deck chairs, but does not add deck chairs.

Read More @ Mises.ca

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