Wednesday, May 10, 2017

3. The Economic Dilemma

To recap yesterday’s lesson in Keynesian finance, limiting the source of financing for new capital formation to past savings not only diverts funds away from consumption (thereby nullifying Adam Smith’s first principle of economics, that production is for consumption), but in order to have production that is not intended for consumption generate the savings necessary to finance new capital and create jobs, demand must be artificially added to the economy so that goods not intended for consumption can be consumed.  Yes, we are fully aware that is a contradiction.  Keynesian economics relies on such things.
Goods produced for non-consumption must still be sold to save.
Of course, as Harold G. Moulton pointed out, if you don’t add demand artificially to the economy when you save for reinvestment, then the production set aside for reinvestment piles up unsold, cutting demand, and instead of sending the economy into a disastrous inflationary upward cost-price spiral, sends it into a disastrous deflationary downward cost-price spiral.
. . . as long as you rely on past savings to fund both consumption and new capital investment, that is.  This, as Moulton expressed it, presents the economy with an “economic dilemma.”  As he put it in Chapter II of The Formation of Capital (1935),
The dilemma may be summarily stated as follows: In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption. The proposition may be made clearer by once more contrasting the roundabout process with the direct process of relatively primitive agricultural communities. When a pioneer farmer created capital by the direct process he did not need to curtail consumption in order to obtain funds with which to increase his capital; he merely devoted his energy; in off seasons, to the improvement of land or to the construction of fences or buildings. But under the modern system of specialized production and exchange the pecuniary savings of individuals are in the main necessarily at the expense of consumption. If an individual with an income of $2,000 elects to save $500 he reduces his potential consumption by one‑fourth. Moreover, the aggregate of individuals who make up society must in a given time period restrict aggregate consumption if funds are to be provided, out of savings, for additional capital construction.
Production is immediate, profits are long term.
It should be noted, also, that when creating additional capital in the form of improved land, buildings, or tools, the primitive farmer was not, immediately speaking, confronted with the question of money profits. The improvements made appeared to add directly to the value of his property holdings; and the increased output which might result from the improvements could presumably be used by the farmer himself or sold in the market. In any event, he was not concerned with the payment of dividends or interest on borrowed funds. He was dependent solely upon himself, and the additions to capital equipment represented the direct fruits of his own labor.
In contrast, when the managers of modern business corporations contemplate the expansion of capital goods they are forced to consider whether such capital will be profitable. They must begin to pay interest upon borrowed funds immediately and they must hold out the hope of relatively early dividends on stock investments. To be sure, there are certain types of speculative enterprise in which capital will be risked for considerable periods of time in the hope of large ultimate profits; but, in the main, returns have to be in prospect relatively soon.
As technology advances, profits become more immediate.
Now the ability to earn interest or profits on new capital depends directly upon the ability to sell the goods which that new capital will produce, and this depends, in the main, upon an expansion in the aggregate demand of the people for consumption goods. A particular corporation may, to be sure, construct new plant and equipment in the face of a declining aggregate demand from consumers, hoping by lower costs and price concessions to take business away from competitors, whose capital will thereby be rendered obsolete; but if the aggregate capital supply of a nation is to be steadily increased it is necessary that the demand for consumption goods expand in rough proportion to the increase in the supply of capital.
To summarize, if people save (i.e., cut consumption) to invest in new capital formation, they no longer have any reason to finance new capital formation because the consumer demand that would justify it does not exist.  If people spend but don’t save, then there isn’t sufficient savings in the system to satisfy the demand for new capital that derives from consumer demand.
. . . as long as you rely on past savings to fund both consumption and new capital investment.
The solution to this seeming paradox?  Future savings, which we’ll look at tomorrow.

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