Why does the economy have to continue expanding?

[davelj]

Holy moly, this thing’s gotten off track. I think some of you folks are over-thinking this issue.

As someone already pointed out above, the REAL economy expands because of population growth and productivity. Over the long term here in the U.S. each has averaged about 1.25-1.50% annually, for real annual growth of 2.5-3.0% per year. That’s the REAL part.

The government tells us that inflation has averaged about 3%/year for some time, although that number is probably more like 4%, or a little more in recent years. The inflation rate, over the long term, is a function of the expansion of the country’s monetary base (for the most part). The monetary base expands as new banks are chartered, the Fed tinkers with interest rates via open market operations (and provides additional liquidity to the system like last week), and tinkers with reserve requirements, among other things. This is how new money is created.

There is nothing inherently wrong with debt or fractional reserve banking. The degree of its inflationary tendencies is all a matter of how the system is managed. And the fact is that while there have been several hundred new banks chartered over the last few years (oh no!! inflation!!), the amount of capital they’ve started with is MINUTE compared with the banks already in operation. Furthermore, most of the deposits that these banks gather come from people switching their accounts over from other banks such that the net effect of new banks throughout the system is negligible from a credit/inflation standpoint. Most of the new banks’ gains come from the pockets of banks already in existence.

In my opinion the inflation from the last several years – particularly in the housing market – has come primarily in the ability of banks to sell mortgages into the secondary markets. This engendered additional demand for mortgages, and thus lower rates (than would otherwise be the case), and eventually looser terms, etc. This, of course, allowed people who could otherwise not get a mortgage to get one, housing prices escalated, and here we are. But that’s now over, for all intents and purposes. We’re in the process of correcting that imbalance.

It’s important to keep in mind, however, that credit/money isn’t necessarily created just because a bank makes a loan. For example, the vast majority of commercial loans aren’t new loans – they’re loans being re-financed and/or moved from one institution to another. And brand new commercial loans are offset by customers who pay off loans and don’t need them anymore; that is, “business births” are offset to some extent by “business deaths.”

Now we’ve had some craziness on the lending side for several years now – not just mortgages, but think of LBOs, etc. – which has caused some inflation (that the government hides from us), but I think those days are over for some time. My guess is that “real” inflation will be somewhat benign for the next 5-10 years unless the Fed screws the pooch in the near-term and tries to bail out Wall Street and marginal SFR borrowers. Then things could get really bizarre.

My point is, don’t overthink the whole fractional reserve issue, non-gold standard issue. Yeah, we’ve got inflation and it’s not going anywhere. It’s certainly worse than what the government tells us, but it’s also not the end of the world. If you don’t get into long-term lending contracts at fixed rates it’s not a big deal.

Personally, I’d rather live in a world of 3%-4% inflation on a regular, expected basis than live in a world where it bounces around negative and positive from year to year. The reason is simple: planning. If I have a reasonable idea of where inflation is headed I (and other businesses) can plan accordingly. If it’s jumping all over the place I and other businesses have a much harder time planning and then maybe we don’t invest as much as a result of the uncertainty, and the economy suffers as a consequence.

The bottom line: We have a fiat currency. Therefore, low to moderate inflation is probably here for our lifetimes and beyond. I don’t fight it. I just plan accordingly. Even though our Central Bankers aren’t perfect (and Greenspan was an out-and-out fraud), over the long term they’ll probably do a moderately o.k. job of managing inflation. So long as you don’t expect any miracles out of them you won’t be disappointed.

[Fearful]

Dave, my thinking exactly. The poor guy just asked a simple question about macroeconomics, and a bunch of survivalists are yelling about stocking up on food and water.

By the way, you are exactly right that predictability is more important than the presence or absence of inflation itself.

[Fearful]

Dave, my thinking exactly. The poor guy just asked a simple question about macroeconomics, and a bunch of survivalists are yelling about stocking up on food and water.

By the way, you are exactly right that predictability is more important than the presence or absence of inflation itself.

[Fearful]

Dave, my thinking exactly. The poor guy just asked a simple question about macroeconomics, and a bunch of survivalists are yelling about stocking up on food and water.

By the way, you are exactly right that predictability is more important than the presence or absence of inflation itself.

[patientrenter]

Gary, your reasoning is spot-on. (Do you really not have a background in economics?) My own knowledge of economics is amateur, so if a professional can set us straight I’d appreciate it. Until then, here are my own rough-hewn thoughts on some more of what you’ve said.

1. “Just like the individual, doesn’t our nation eventually either have to walk away on its debt obligations or begin to make some very drastic and painful changes in spending?”

Precisely. If we do walk away from those obligations (by letting the dollar devalue), we’ll still have to reduce spending, because we won’t have access to new sources of money. But at least we won’t have to reduce spending enough to repay all the excess money we’ve spent in the prior decades. Another part of the solution could be exporting more. We’ll have to do better at making things or services foreigners want.

2. ” ‘For the simple reasons that population is growing and the productivity is also growing. Do the math, if GDP does not grow, the hours worked per person must drop.’

I’m not overly informed I guess, but this doesn’t make sense to me.”

I think the sustainable growth in $ money is the sum of growth in working population, growth in (real) productivity, and inflation. I know you’re saying real productivity may be overstated. Could be. But when it’s measured correctly, you get the conclusion I describe above. E.g. total sustainable money growth = 1.5% (pop) + 1.5% (real productivity) + 3% (inflation) = 6%. I’d guess 4-7% is a reasonable range.

3. “Erring continuously on the side of inflation must certainly have eventual consequence.”

Not inevitably. Savers may get tired of getting hit by inflation, but will that stop people like me who need high levels of financial security from saving? Not much. So the effect could be small. We all need to save some for retirement, regardless of how unattractive the return may get, or for how long.

4. “How long can we continue to put off eventual repayment of our collective debts?”

A long time. If we spend 5% more than we save, it would take 20 years for the extra debt (in real terms) to amount to one year’s income. That’s a lot, but not impossible.

Is today’s state fragile, though? Yes, I think so. Asset prices are maybe 15 times what they were back at the last trough in 1979-1981. After inflation, maybe 5-7 times. Corporate earnings are a bigger % of our GDP than ever before, maybe twice the average, so P/E ratios have a questionable long-term e. Clearly we’re more likely to be at a peak than an average. And importing more than we export to the tune of 5% of our GDP is historically high.

But people want more. People in other countries desperately want more, and know how to get it. The world’s economy will keep growing. So the end of all this fragility is unlikely to be a depression, just some cinching of US belts and a new focus on making more exportable goods and services.

Patient renter in OC

[patientrenter]

Gary, your reasoning is spot-on. (Do you really not have a background in economics?) My own knowledge of economics is amateur, so if a professional can set us straight I’d appreciate it. Until then, here are my own rough-hewn thoughts on some more of what you’ve said.

1. “Just like the individual, doesn’t our nation eventually either have to walk away on its debt obligations or begin to make some very drastic and painful changes in spending?”

Precisely. If we do walk away from those obligations (by letting the dollar devalue), we’ll still have to reduce spending, because we won’t have access to new sources of money. But at least we won’t have to reduce spending enough to repay all the excess money we’ve spent in the prior decades. Another part of the solution could be exporting more. We’ll have to do better at making things or services foreigners want.

2. ” ‘For the simple reasons that population is growing and the productivity is also growing. Do the math, if GDP does not grow, the hours worked per person must drop.’

I’m not overly informed I guess, but this doesn’t make sense to me.”

I think the sustainable growth in $ money is the sum of growth in working population, growth in (real) productivity, and inflation. I know you’re saying real productivity may be overstated. Could be. But when it’s measured correctly, you get the conclusion I describe above. E.g. total sustainable money growth = 1.5% (pop) + 1.5% (real productivity) + 3% (inflation) = 6%. I’d guess 4-7% is a reasonable range.

3. “Erring continuously on the side of inflation must certainly have eventual consequence.”

Not inevitably. Savers may get tired of getting hit by inflation, but will that stop people like me who need high levels of financial security from saving? Not much. So the effect could be small. We all need to save some for retirement, regardless of how unattractive the return may get, or for how long.

4. “How long can we continue to put off eventual repayment of our collective debts?”

A long time. If we spend 5% more than we save, it would take 20 years for the extra debt (in real terms) to amount to one year’s income. That’s a lot, but not impossible.

Is today’s state fragile, though? Yes, I think so. Asset prices are maybe 15 times what they were back at the last trough in 1979-1981. After inflation, maybe 5-7 times. Corporate earnings are a bigger % of our GDP than ever before, maybe twice the average, so P/E ratios have a questionable long-term e. Clearly we’re more likely to be at a peak than an average. And importing more than we export to the tune of 5% of our GDP is historically high.

But people want more. People in other countries desperately want more, and know how to get it. The world’s economy will keep growing. So the end of all this fragility is unlikely to be a depression, just some cinching of US belts and a new focus on making more exportable goods and services.

Patient renter in OC

[patientrenter]

Gary, your reasoning is spot-on. (Do you really not have a background in economics?) My own knowledge of economics is amateur, so if a professional can set us straight I’d appreciate it. Until then, here are my own rough-hewn thoughts on some more of what you’ve said.

1. “Just like the individual, doesn’t our nation eventually either have to walk away on its debt obligations or begin to make some very drastic and painful changes in spending?”

Precisely. If we do walk away from those obligations (by letting the dollar devalue), we’ll still have to reduce spending, because we won’t have access to new sources of money. But at least we won’t have to reduce spending enough to repay all the excess money we’ve spent in the prior decades. Another part of the solution could be exporting more. We’ll have to do better at making things or services foreigners want.

2. ” ‘For the simple reasons that population is growing and the productivity is also growing. Do the math, if GDP does not grow, the hours worked per person must drop.’

I’m not overly informed I guess, but this doesn’t make sense to me.”

I think the sustainable growth in $ money is the sum of growth in working population, growth in (real) productivity, and inflation. I know you’re saying real productivity may be overstated. Could be. But when it’s measured correctly, you get the conclusion I describe above. E.g. total sustainable money growth = 1.5% (pop) + 1.5% (real productivity) + 3% (inflation) = 6%. I’d guess 4-7% is a reasonable range.

3. “Erring continuously on the side of inflation must certainly have eventual consequence.”

Not inevitably. Savers may get tired of getting hit by inflation, but will that stop people like me who need high levels of financial security from saving? Not much. So the effect could be small. We all need to save some for retirement, regardless of how unattractive the return may get, or for how long.

4. “How long can we continue to put off eventual repayment of our collective debts?”

A long time. If we spend 5% more than we save, it would take 20 years for the extra debt (in real terms) to amount to one year’s income. That’s a lot, but not impossible.

Is today’s state fragile, though? Yes, I think so. Asset prices are maybe 15 times what they were back at the last trough in 1979-1981. After inflation, maybe 5-7 times. Corporate earnings are a bigger % of our GDP than ever before, maybe twice the average, so P/E ratios have a questionable long-term e. Clearly we’re more likely to be at a peak than an average. And importing more than we export to the tune of 5% of our GDP is historically high.

But people want more. People in other countries desperately want more, and know how to get it. The world’s economy will keep growing. So the end of all this fragility is unlikely to be a depression, just some cinching of US belts and a new focus on making more exportable goods and services.

Patient renter in OC

[one_muggle]

4. “How long can we continue to put off eventual repayment of our collective debts?”

From what I understand, the USG does not and cannot invest or save money, at least in any traditional way. Sure it can “invest” in R&D or infrastructure, but it does not have a vehicle in which to put money aside. The fed may insert or remove money from supply, but this is not the same as, say buying stock in IBM or a CD. There is no lockbox, the funds received are spent, and some of it is spent to service debt.
Uncle Sam can (and should) limit how much debt it takes on, because the future debt service can become manageable, but it cannot set money aside for the future, except by paying down existing debt.
The Chinese government is actually quite an active capitalist, since it owns several profitable businesses, but that is socialism, which we don’t do because we are capitalists… But thinking about that makes my head hurt. Damned commies, can’t they do anything right!

-one muggle

[one_muggle]

4. “How long can we continue to put off eventual repayment of our collective debts?”

From what I understand, the USG does not and cannot invest or save money, at least in any traditional way. Sure it can “invest” in R&D or infrastructure, but it does not have a vehicle in which to put money aside. The fed may insert or remove money from supply, but this is not the same as, say buying stock in IBM or a CD. There is no lockbox, the funds received are spent, and some of it is spent to service debt.
Uncle Sam can (and should) limit how much debt it takes on, because the future debt service can become manageable, but it cannot set money aside for the future, except by paying down existing debt.
The Chinese government is actually quite an active capitalist, since it owns several profitable businesses, but that is socialism, which we don’t do because we are capitalists… But thinking about that makes my head hurt. Damned commies, can’t they do anything right!

-one muggle

[one_muggle]

4. “How long can we continue to put off eventual repayment of our collective debts?”

From what I understand, the USG does not and cannot invest or save money, at least in any traditional way. Sure it can “invest” in R&D or infrastructure, but it does not have a vehicle in which to put money aside. The fed may insert or remove money from supply, but this is not the same as, say buying stock in IBM or a CD. There is no lockbox, the funds received are spent, and some of it is spent to service debt.
Uncle Sam can (and should) limit how much debt it takes on, because the future debt service can become manageable, but it cannot set money aside for the future, except by paying down existing debt.
The Chinese government is actually quite an active capitalist, since it owns several profitable businesses, but that is socialism, which we don’t do because we are capitalists… But thinking about that makes my head hurt. Damned commies, can’t they do anything right!

-one muggle

[Anonymous]

“Isn’t GDP simply a measure of the total dollars spent”

No. GDP measures real growth of domestic value add in production and services. So producing two of the same things instead of one counts as growth. Simply selling the same thing at twice the price does not. The nominal GDP (dollar spent) is deflated by the “GDP deflator” to arrive at the real GDP. Now lots of adjustments go into the GDP deflator, since we don’t simply make more of the same things all the time as a commodity producer would do, we make different things too. So there is real debate about these adjustments. (Google “hedonistic” adjustments).

Yes for the monetary system to function we do need a bit of positive inflation. It is like maintaining pressure in a plumbing system. It drives cash towards spending or investment so that it does not pile up somewhere excessively.

Saving at the national level is a very different concept from individuals. If our economy were closed (no trade with other nations) we can’t really collectively save. Yes it is possible to build up some inventory, but foods go bad over time, clothings go out of fashion, so we don’t want to build up too much of inventory and most importantly every hour elapsed is time lost that is never going to come back. In other words, over 70% of our economy is composed of services that can not even be inventoried/saved. Saving cash as a nation (when the economy is closed) is meaningless since that merely represents internal claims that is cancelled out by internal obligations. As a nation that trades with others we could save if we accumulate surpluses (claims on other nations) but then in the world as a whole there can be little net savings.

[Anonymous]

“Isn’t GDP simply a measure of the total dollars spent”

No. GDP measures real growth of domestic value add in production and services. So producing two of the same things instead of one counts as growth. Simply selling the same thing at twice the price does not. The nominal GDP (dollar spent) is deflated by the “GDP deflator” to arrive at the real GDP. Now lots of adjustments go into the GDP deflator, since we don’t simply make more of the same things all the time as a commodity producer would do, we make different things too. So there is real debate about these adjustments. (Google “hedonistic” adjustments).

Yes for the monetary system to function we do need a bit of positive inflation. It is like maintaining pressure in a plumbing system. It drives cash towards spending or investment so that it does not pile up somewhere excessively.

Saving at the national level is a very different concept from individuals. If our economy were closed (no trade with other nations) we can’t really collectively save. Yes it is possible to build up some inventory, but foods go bad over time, clothings go out of fashion, so we don’t want to build up too much of inventory and most importantly every hour elapsed is time lost that is never going to come back. In other words, over 70% of our economy is composed of services that can not even be inventoried/saved. Saving cash as a nation (when the economy is closed) is meaningless since that merely represents internal claims that is cancelled out by internal obligations. As a nation that trades with others we could save if we accumulate surpluses (claims on other nations) but then in the world as a whole there can be little net savings.

[Anonymous]

“Isn’t GDP simply a measure of the total dollars spent”

No. GDP measures real growth of domestic value add in production and services. So producing two of the same things instead of one counts as growth. Simply selling the same thing at twice the price does not. The nominal GDP (dollar spent) is deflated by the “GDP deflator” to arrive at the real GDP. Now lots of adjustments go into the GDP deflator, since we don’t simply make more of the same things all the time as a commodity producer would do, we make different things too. So there is real debate about these adjustments. (Google “hedonistic” adjustments).

Yes for the monetary system to function we do need a bit of positive inflation. It is like maintaining pressure in a plumbing system. It drives cash towards spending or investment so that it does not pile up somewhere excessively.

Saving at the national level is a very different concept from individuals. If our economy were closed (no trade with other nations) we can’t really collectively save. Yes it is possible to build up some inventory, but foods go bad over time, clothings go out of fashion, so we don’t want to build up too much of inventory and most importantly every hour elapsed is time lost that is never going to come back. In other words, over 70% of our economy is composed of services that can not even be inventoried/saved. Saving cash as a nation (when the economy is closed) is meaningless since that merely represents internal claims that is cancelled out by internal obligations. As a nation that trades with others we could save if we accumulate surpluses (claims on other nations) but then in the world as a whole there can be little net savings.

[Author]

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