Austrian vs Keynesian Economics, Deficit hawks vs Deficit Doves

In the last couple of posts, we had concluded that it is okay to not address the debt problem being faced by the US/Europe right away in the middle of a recession. The prescription we had in mind was to focus more on creating jobs rather than tackling the rising debt because the debt is not coming due any time soon. This is similar to the stand taken by Keynesian economists (most prominent of them being the nobel laureate - Paul Krugman) but completely contrary to that of Austrian economists (economists from the Austrian school of thought, the most prominent believer of them being Congressman Ron Paul who was bested by Mitt Romney in the Republican primaries).

Debate has been raging on between the two schools for a long time showing that economics is more of an art than science. Check out the highly popular debate between the two Pauls (http://www.youtube.com/watch?v=WEoGKpnutyA&feature=related ) on YouTube. If you don't make head or tail out of this highly anticipated debate - fret not! Here's the lay economist to the rescue.

Actually, we were concerned that the conclusions made in the last two posts went against traditional wisdom dished out to individuals - a) live within ones means; b) do not live off of potential future earnings. After considerable head scratching, we believe we are able to understand the assumptions made by the Austrian economists (as applied to our village) and we are still standing firm behind our earlier prescription.

Let's visit our village to get an idea of what Austrian and Keynesian principles are (Please read: http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html for some background). There we had seen that when recession hit the village, Wesley had three options.

1. Tax-cuts and easing of regulations
2. Active government stimulus
3. Quantitative Easing

If Wesley is of Austrian school of thought then he should choose option 1 and simply step out of the way, cut taxes and regulations and let the markets take their own free course. If Wesley is of Keynesian school of thought then he should follow the other options 2 and 3, namely quantitative easing  and active government stimulus (Again, please see: http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html).

The Austrian economists believe the following (among many others):

1. The boom and bust cycles are due to the power of issuing GOUs bestowed upon governments.
2. Governments are capable of abusing their power of issuing GOUs to distort the markets and fund unpopular programs that the governments believe are necessary.
3. If the government issues unlimited GOUs (like we had discussed in http://layconomics.blogspot.com/2012/11/is-public-debt-really-that-terrible.html) then it will cause inflation by lowering the value of GOUs. Why? Simply because there are too many GOUs floating around in the economy (this is not true - as we will see later).
1. Actually, the scenario the economists paint is even more dire where they predict the collapse of the entire currency market (e.g. the US dollar) - where the GOUs have no value and people holding tons of GOUs will be left holding the bag unable to exchange the GOUs for any goods of value.
4. The government should completely step out of the way and let the markets decide how to revive the economy.
5. The capital for investment should come from savings and not from debt (GOUs).

In our opinion, (Very Important - we keep raising this over and over) given that:

1. all the basic needs of the modern society can be satisfied by a segment of the society,
2. humans are capable of producing more goods if sufficiently motivated (elastic capacity) and,
3. the same humans are capable of finding new needs and wants (where none existed before),

the Austrian school of thought is a little anachronistic. 

Please consider the following arguments:

1. Somebody should have the power to issue GOUs or non government equivalents (IOUs) - Without IOUs, in a society where some of the goods have a shelf life (e.g. fresh food), future investments/savings and the GDP are necessarily lower. Let's see why. Without IOUs, productive members of goods (destined for immediate consumption) will only barter with other productive members, leaving non-productive members out of the loop even if they can be productive in the future. This will also mean that those productive members will only produce as much as required for their own needs and for the purposes of barter. They will not produce for the non-productive members, even if they are capable, because they will get nothing in return (remember! IOUs don't count) and any extra produce, if not immediately consumed, is wasted. This means that IOUs are important and GOUs which are IOUs with governmental backing carry even more weight.
1. In the US, the power to issue GOUs lies with the Federal Reserve (printing of money) and the power to issue IOUs lies with the banks (via fractional reserve lending).
2. More GOUs/IOUs does not necessarily cause inflation - GOUs/IOUs issued for goods are necessarily for consumption by currently non-productive members of the society (unless people misuse them for hoarding goods and speculation - even then production can rise to meet this imaginary demand). Note that the productive members have the capacity to expand production to meet the demand from the non-productive members given life via said GOUs/IOUs.
3. Power to issue GOUs need not be unlimited - In a democracy, no government has the power to issue GOUs endlessly to fund unpopular programs.
4. Issuing GOUs/IOUs increases real GDP - GOUs/IOUs issued to productive members increases production of goods of actual value (since they are for the consumption by non-productive members).
5. GOUs are definitely more popular than taxes - After all, who wants to keep producing something for nothing.
6. Booms and busts are related to investments regardless of whether they are from GOUs/IOUs or savings - Austrian school of thought claims that GOUs/IOUs allow for massive mis-investments causing huge busts when the investments don't pan out in unison. However, the potential to mis-invest does not lie with the government alone. Even private businessmen have the potential to mis-invest enmasse based on the latest hot investment idea (the housing and internet bubbles come to mind).

Given these arguments, it is clear to us that GOUs are not the monsters they are made out to be. Does this mean that we can let the debt build on itself forever as long as we can guarantee that people are able to use their GOUs to obtain goods and services as and when they want it? In an ideal situation, yes. However, the health of the economy is heavily dependent on the sentiment of the members. If the society suddenly loses confidence in the GOUs (because they get spooked out by the number of GOUs floating around) then the newer members of the society might stop accepting GOUs in exchange for their products. All the members in possession of GOUs thinking they have a certain amount of wealth will end up with nothing. This should give us a good idea why the Austrian school of thought appeals to the rich. After all, this guarantees there is no chance, however remote, of their wealth suddenly transforming to nothing.

Is it imperative to immediately tackle growing external debt?

We saw, in the previous post, how tackling internal debt is not really of immediate paramount importance for the following reasons:

1. It is a debt that people owe to themselves.
2. (Very important) As long as a subset of the population is able to satisfy all needs of the entire population, the debt can be transferred to the future (i.e. it will NOT be required to be settled immediately) and to top it off, new debt can be created because:
1. ALL immediate current needs of the productive section of society can be satisfied via exchange within the section itself - producers can exchange their goods for goods from other productive members of the society.
2. ALL future needs of all producers in the society can be satisfied via generation of new public debt. Producers can not expect their "needs" to be satisfied if those needs are not currently being produced by somebody else.
3. The productive members will be willing to produce for the non-productive members of the society as long as there is a promise of future pay off (new debt - similar to point 2 above).
4. People holding public debt can use that debt to obtain goods from productive members either in the form of higher taxes (in which case the debt is reduced) or in the form of debt transfer.
3. If required, the government has the power and authority to default, impose taxes and force productivity increase to address the debt. This step will only have to be taken if the part of the population holding the debt becomes adamant in using their credit to obtain goods rather than working and using their productivity to pay for their needs and wants.

However, does the same apply to external debt? External debt is different from internal debt because now the government does not have the authority to impose taxes and force productivity increase on creditors. Default is always an option but we are leaving that off the table for now. Will the creditors demand settlement, thus forcing the society to shed its assets and/or work harder to satisfy that demand?

We will see how in the case of external debt that it will not come due any time soon either. For that we have to understand how external debt is created and how at this moment the society of external creditors works.

We already know that external debt is created when a country (or society) obtains goods from another country with the promise of future pay-off. What is remaining is - understanding how the economy of the creditor country works.

We will limit our discussion to the situation currently involving the US, Europe and China. As luck would have it, China also satisfies the condition of a subset of its population being able to produce for the entire country. Keep in mind though that the goods that are "required" in China are much smaller in number than in the West (China has not graduated to a consumption based economy yet - please see http://layconomics.blogspot.com/2012/11/the-us-european-and-chinese-economies.html). Therefore, in China, there is a whole segment of low-skilled population that is not producing what Chinese citizens want. China has the following options:

1. Let that segment starve. This is definitely not desirable.
2. Put that entire segment on welfare by forcing the productive members to produce for the entire society. These are what we refer to as high taxes on productive members. This situation is not desirable either.
3. Put that segment on welfare by paying the productive members using GOUs (Government-owes-U) for their goods. This is better than option 1 and 2 but not the most optimal because it raises debt without any accompanying benefits. 
4. Put that segment to work in some manner or the other to make them earn their "wages". These take two forms:
1. Investment in the form of making them work on something that might possibly be useful in the future. This raises debt but also gives government investments that might pay-off in the future. BTW, the massive infrastructure projects being undertaken in China fall under this category.
2. Produce goods for the West hoping to get something in return. However, at the moment there are very few things the Chinese want from Western countries as is evident from the huge trade deficit. All China is getting are promises of future pay off. This is still better than options 1, 2 and 3 listed above.

(Very important) What the above means is that China will neither demand settlement nor stop buying more US/Europe debt because:

1. There are no goods that the US or Europe produce that the Chinese consider desirable (demand in China is still low for any goods manufactured in the West).
2. There are no goods that the non-productive population of China can currently produce that the Chinese consider diserable (demand in China is still low for any consumer goods produced by Chinese labor for Western markets).
3. As long as both points above are true, China has no choice but to employ its population in producing goods for the West and to continue accepting the US and Europe GOUs in return.

This picture will change, if:

1. The Chinese society gets transformed into a consumption based society where the goods currently being produced for the West become desirable within China. In that case, China might stop producing goods for the West in exchange for a simple promise of future pay-off and/or the price of the goods from China will go up. This is acceptable because this does not mean that the debt will have to be settled immediately. However, the citizens of the US and Europe will have to give up their expectation of low priced goods from China.
2. The US and Europe start producing goods that the Chinese consider desirable. In this case, China will demand settlement and the US and Europe will be obliged to work harder to settle that demand. This is highly desirable because it brings down the external debt while at the same time creating jobs in the West.

As you can see, there is nothing that shows that the external debt is disastrous and needs to be confronted immediately. However, it would be desirable to keep the debt from growing by reducing consumption of Chinese manufactured goods. Tackling external debt can be deferred to the future and this gives us a chance to focus on more immediate task of creating jobs instead of worrying ourselves sick about crushing debt.

Is public debt really that terrible?

 

Recently, every tom, dick and harry (and not to forget their brother) has been clamoring about the fiscal cliff looming in front of us. The cliff is in place to ensure that federal deficit and public debt do not spiral out of control. However, the following questions can be asked. Is such a drastic step of following through with the fiscal cliff really necessary? Is it really imperative for us to solve the debt crisis immediately in the middle of a recession? Finally, is public debt really this monster that it is made out to be? Let's explore using our village as the backdrop.

We have established in a previous post (http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html) that Government-Owes-U is what really constitutes public debt. We have understood that generation of GOUs only happens in those situations where people barter the goods they are producing not for other goods but for the promise of future pay-off from the government. The government instead of simply taking the goods away as "taxes", and creating an unhappy populace,  does the next best thing of giving them the promise of future pay-off for their goods (or services).

In our village setting, we saw that Wesley used the GOUs in the following manner (during the recession):

1. To support Debbie's and Billy's welfare.
2. To invest in Billy and employ him in building a bridge for the village and kickstart the economy.
3. To enable tax-breaks for Fannie, Henry and Taylor so that they can kickstart the economy by employing Billy.

 

However, Wesley can still use the GOUs even when there's no recession to:

1. Enable tax-breaks for Fannie, Henry, Debbie, Billy and Taylor so that they can invest outside the village and expand the economy further
2. Have the government invest in somebody outside of the village:
1. to prepare for the future
2. to expand the economy

 

In each case, Wesley's hope is that fulfilling the obligations for GOUs in the future will be easier because:

1. The economy has grown and the public's investment (via the government) has paid off. The government can easily share the returns of the investment back with the people.
2. The economy has grown and the public does not mind paying "taxes" in the future rather than in the present

As an aside, note that, in a perverse sense, it is the same villagers owning the GOUs who might be "taxed" to fulfil the obligations (this is actually true for internal debt) so fulfilling the obligations will involve paying oneself. Of course, people owning the GOUs will try their hardest to avoid being the ones who have to fulfil the obligations.  

To determine whether the debt problem should be tackled immediately by Wesley, it is imperative to note that GOU obligations will have to fulfilled immediately only if all three of the following conditions are true at the same time:

1. There is an immediate need for products that somebody is already producing that the GOU owners "need".
2. The GOU owner does not have anything he can use to barter for his "need"  (this is similar to Debbie and Billy's situation during the recession when they had nothing to barter for things that they needed).
3. (very important) The "in-demand" producer is unwilling to compromise on future pay-off for his product.

 

Since, all three conditions listed can not be true as long as a percentage of the population can fully support the entire village's needs, Wesley can rest easy that the "debt crisis" is not really an immediate crisis and he can tackle it at a better time in the future.

However, if the events conspire to demand action from Wesley then there are multiple ways for him to deal with the situation:

1. He can void the GOUs (default on the debt) and simply say that people should have actually paid taxes in the past instead of getting a pass like they did.
2. He can "tax" the villagers by allowing people to use their GOUs to demand from their neighbor a product that they "need". Exercising this option is what is called the "fiscal cliff".
3. He can sell the rights to public assets to fulfil the obligations (e.g. the bridge) - which works only if the in-demand producer thinks that he "needs" the bridge. This is what is called privatization to raise capital.

 

Otherwise,

1. He can wait for a time when people do not mind giving up something for nothing (when the economy is humming along) and reduce some of the obligations at that time. This would be equivalent to raising "taxes" during good times.
2. He can allow the GOUs to be transferred by letting in-demand producers to retain the GOUs and using them for a future pay-off (which is the best thing for him to do during a recession).
1. "But this is just delaying the problem" could be the refrain. If transferring the debt goes on ad infinitum there will come a time when there are people who are left holding the bag when there is nothing for them to redeem using their GOUs. However, this is an implausible Mad Max scenario and God forbid we ever get there because debt crisis will not be the worst crisis we will be facing at that point.

The US, European and Chinese economies demystified

In this post, we try to describe how some major economies of the world currently function by revisiting our village and understanding how it would look if it followed the model of each of those economies. We do this again without using the concept of money (only partly true because we use the concept of Government-Owes-U and money is nothing but a special form of GOU).

Note that what we are trying to describe certainly does not capture each and every nuanced detail of the economies. Note also that another layconomist might differ from us on the salient aspects of each economy that should be highlighted.

The US economy

If the village followed the current US economic model it might look like the following:

1. Wesley would be employed in the government and use his services to barter for produce, meat, shelter, clothes and GOUs. He might use IOUs to barter for toys. He would also be responsible for using GOUs to barter for produce, meat, shelter and clothes within the village on Debbie's behalf. Finally, He would be responsible for using GOUs to barter for toys with China on the village's behalf.
2. Fannie would be employed as a farmer and use her produce to barter for meat, shelter, clothes and GOUs. She might use IOUs to barter for toys. She would be paying "taxes" in the form of bartering her produce for Wesley's services.
3. Henry would be employed as a hunter and use his meat to barter for produce, shelter, clothes and GOUs. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his meat for Wesley's services.
4. Billy would be employed as a builder and use his shelter to barter for produce, meat, clothes and GOUs. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services.
5. Taylor would be employed as a tailor and use his clothes to barter for produce, meat, shelter and GOUs. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services.
6. Debbie is currently unemployed and using IOUs to barter for shelter, clothes and toys while getting produce and meat for free from the government (welfare). She might be training herself to produce something of value in the future that she can use to not only fulfil her IOUs but also to use for bartering in the future.
7. Main points:
1. The internal debt is in the form of GOUs to Fannie, Henry, Billy and Taylor that can be repaid whenever Debbie fulfils her IOUs. The external debt is in the form of GOUs to China that is balanced out by the IOUs that the villagers have to repay. The GOUs to China can be repaid in the future by having everybody work a little harder (if China is interested in what the village produces) which incidentally also allows the villagers to fulfil their IOU obligations.
2. The IOUs that people are using to barter for toys is what we would call consumer/credit card debt.
3. The GOUs that were used to barter for toys is essentially the $1.1 trillion that the US currently owes to China.
4. The $11.1 trillion public debt owed to Americans is essentially the internal debt in the form of GOUs to Fannie, Henry, Billy and Taylor.

European economy

If the village followed the current European economic model it might look like the following:

1. Wesley would be employed in the government and use his services to barter for produce, meat, shelter, and clothes. He might be using IOUs to barter for toys. He would also be responsible for collecting produce, meat, shelter and clothes from within the village in the form of extra "taxes" on Debbie's behalf. He would also be responsible for using GOUs to barter for toys with China on the village's behalf.
2. Fannie would be employed as a farmer and use her produce to barter for meat, shelter and clothes. She might use IOUs to barter for toys. She would be paying "taxes" in the form of bartering her produce for Wesley's services and simply covering Debbie's welfare.
3. Henry would be employed as a hunter and use his meat to barter for produce, shelter and clothes. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his meat for Wesley's services and simply covering Debbie's welfare.
4. Billy would be employed as a builder and use his shelter to barter for produce, meat and clothes. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services and simply covering Debbie's welfare.
5. Taylor would be employed as a tailor and use his clothes to barter for produce, meat and shelter. He might use IOUs to barter for toys. He would be paying "taxes" in the form of bartering his shelter for Wesley's services and simply covering Debbie's welfare.
6. Debbie is currently unemployed and using IOUs to barter for toys while getting shelter, clothes, produce and meat for free from the government (welfare). She might be training herself to produce something of value in the future that she can use to not only fulfil her IOUs but also to use for bartering in the future.
7. Main points:
1. In this particular scenario, there is no internal debt in the form of GOUs to Fannie, Henry, Billy and Taylor because Wesley instead of using GOUs to obtain the extra products simply got them by levying extra "taxes". The external debt is in the form of GOUs to China that is balanced out by the IOUs that the villagers have to repay. The GOUs to China can be repaid in the future by having everybody work a little harder (if China is interested in what the village produces) which incidentally also allows the villagers to fulfil their IOU obligations.
2. Alternatively, under the European model Wesley could have used GOUs instead of higher taxes to pay for Debbie's welfare just like in the US model described earlier. This would result in higher internal debt than in the US model because there are fewer Debbie's IOUs to balance out the higher number of GOUs issued.
3. The point to be highlighted is that welfare support in the European model is broader than in the US model. Broader welfare is supported either through higher taxes or by increasing debt or a combination of both.

Chinese Economy

If the village followed the Chinese economic model it would look like the following:

1. Wesley would be employed in the government and use his services to barter for produce and shelter. He would be responsible for using toys produced by Taylor to barter for the US and European GOUs. He would also be responsible for collecting produce from Fannie and Henry for Debbie. Finally, he would be responsible for using GOUs to barter for shelter and produce on Taylor's behalf.
2. Fannie and Henry would both be employed as farmers and use their produce to barter for GOUs and shelter that they will share together. They would be paying "taxes" in the form of bartering their produce for Wesley's services and Debbie's welfare.
3. Billy would be employed as a builder and use his shelter to barter for produce and Wesley's services. Wesley as part of the government also employs Billy to build more than required by other villagers in the hope that the shelter he is building will be in demand in the future. Billy uses the extra shelter he builds to barter for GOUs. He would be paying "taxes" in the form of bartering his shelter for Wesley's services and Debbie's welfare.
4. Taylor would NOT be employed as a tailor but as a toy maker using the know-how from the US and Europe. He would use his toys to barter with Wesley (who is acting as Taylor's proxy to barter with Fannie, Henry and Billy) for produce and shelter which he shares with Debbie. He would be paying "taxes" in the form of bartering his toys for Wesley's services and Debbie's welfare.
5. Debbie is currently unemployed while getting produce for free from the government (welfare) while sharing the shelter with Taylor. She might be training herself to produce something of value in the future to use for bartering in the future.
6. Main points:
1. There is some government debt in the form of GOUs to Fannie, Henry and Billy. There is no external debt and to put some icing on the cake there is external credit in the form of European and the US GOUs to China. China can use the GOUs to get something from Europe and the US if it is interested at some point in what those villages produce.
2. The productivity of Chinese farmers is lower than that of those in Europe and US because a greater fraction of the villagers are required to produce enough food for the entire village. This cuts down the amount of food avaiiable to each villager in China.
3. The villagers do not see any need to use their hard work to barter for clothes which they feel is a luxury.
4. The villagers do not see any need to own individual shelters when they can share it with somebody else. They would rather save (in the form of GOUs) than use their hardwork to barter for things they don't feel is a necessity.
5. Basically, the point to be highlighted is that the villagers are not making/producing something that other villagers would want. That is, China has not transitioned to a consumption based economy where people feel the need to satisfy their many desires. However, they are producing something that will satisfy the desires of inhabitants of other villages. For this they are getting Chinese GOUs in exchange. The Chinese villagers are holding on to their GOUs hoping to exchange it for something they might want in the future.
6. It's quite possible to exchange US GOUs for European GOUs and Chinese GOUs and vice-versa at some exchange rate that we will explore at a later stage.