Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

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-- Brad Delong

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Monday, August 8, 2011

The Secrets of Capitalism

The dirty little secret of capitalism is that it is totally dependent on consumption.  This shouldn't really be much of a secret, since it is hiding in plain sight, but I guess it is, since NOBODY EVER TALKS ABOUT IT.

The deep, dark dirty secret of capitalism is that it needs inflation.  That's right folks it NEEDS inflation.  Right now, we don't have any (or at east not any worth talking about - though that doesn't stop the buffoons from prattling on) and capitalism is in the sewer.

The ship is sinking and deflation is what will take it down.  At least in part, this is the unwinding of the debt binge we experienced over the past few decades.


Stagflationary Mark said...

An economy should be able to function without population growth. For example, we should not need to grow the US population to a billion in order to prosper.

A ponzi economy requires growth in order to function though (so we can borrow from the future relatively painlessly to fund today's prosperity).

Inflation offers pretend growth and cannot feed a ponzi economy with the sustenance it requires.

We have seen this effect twice in the last decade. The first time was when oil hit $145+ and the second was more recently when oil climbed back to $100+. And how did we get oil to these levels? Inflation. And what was the result? Prosperity vanished.

The rub has been that government has been exceptionally able in printing money and creating promises, but is unable to print gold or create oil.
- Warren Buffett (1979)

Just opinions of course.

BadTux said...

Mark, there is no capitalism without capital, and there is no capital without inflation (since money simply sits under mattresses without inflation). Remember, the whole *point* of money is to use as a medium of exchange. Its use as a store of value is necessary for the short period of time between selling a good or service, and buying a good or service, but money under a mattress as a long-term store of value effectively ceases to exist from the perspective of the economy, and does nothing (zero, nada, zilch) to facilitate economic activity. Only inflation can force that money out from under mattresses and back into the economy, because only inflation tells people, "if you stuff money under your mattress, it will lose value."

Without inflation, the effective money supply collapses due to the mattress money problem and two things happen: a) debt inflation (i.e., the value of debts in real terms rises until the point that they are unpayable), and b) the reduction of large sections of the economy to barter due to lack of money to facilitate those transactions. And barter is a woefully inefficient way to run an economy -- when a significant portion of the economy was reduced to barter in 1932, the number of economic transactions taking place plummeted drastically.

In short, without inflation, there is no capital, and thus no capitalism. Them's just the facts, jack. And given that I think capitalism is a *good* thing (can you point to any other system of economic organization capable of generating wealth as well as capitalism does), well...

- Badtux the Capitalist Penguin

Jazzbumpa said...

Mark -

I appreciate your opinions.

Growth - in the abstract, you might have a point. But, IMHO, population is like love and the moon: it either waxes or wanes, and there is no stasis. I don't know of any historical precedent for stable population size.

Ponzi - Is capitalism a Ponzi scheme? Maybe so. I've never pndered that question. But borrowing from the future is not necessarily Ponzi. It enables current investment that eventually enables paying the incurred debt in the future, plus enhancing wealth at the margin. That's why I deferred my earning power to attend college - back in the 60's when it had value to do so.

Inflation - But without what you call "pretend growth," there can be no real growth, either.

What we've seen over the last decade is rolling bubbles, and gold is the last of them. This is really quite a different phenomenon, related to asset misallocation into rent-seeking (in a very broad sense) rather than investment (in a very narrow sense.) Prosperity vanished with the bursting of these bubbles. Note that this has all occurred in a disinflationary environment.

We are teetering on the brink of deflation. That is ruinous to capitalism, and that is why I am so intensely pessimistic, even over a term of several years.

Good quote from Buffett - it makes a fine sound bite. But without government, oil does not get pumped, transported and refined, and brigands take your gold.


Jazzbumpa said...

Tux -

I hadn't seen your comment when I responded to Mark. I totally agree with you.

The cash lying fallow in corporate coffers and bank excess reserves illustrates your point.

I'll add that we have moved beyond capitalism to an era of trans-national mega-corporatism. These entities have no loyalty to anyone or anything - which explains the eagerness to export jobs to boost the bottom line, and the eagerness to divert profits through the Cayman islands to avoid taxation.


Jerry Critter said...

Which comes first? Does inflation cause an increase in the money supply, or does an increase in money supply cause inflation?

Jazzbumpa said...

Jerry -

I have no idea.


Stagflationary Mark said...


Mark, there is no capitalism without capital, and there is no capital without inflation (since money simply sits under mattresses without inflation).

There was plenty of growth in the 1800s and the decade overall was deflationary. There was no need to stuff money under mattresses because there was a long-term compelling reason to invest.

Inflation / Deflation Chart Since 1800

Isn't it interesting that inflation has risen with the Federal Reserve Bank's designed increase in consumer debt.

This is a chicken and the eggs problem.

We have the debt because we embraced inflation. We now apparently "need" the inflation because we embraced debt.

Worse, as we attempt to inflate the inflation shows up in the wrong place first. Savers save. If you force a saver to spend then he turns into a hoarder. Hoarding behavior does not lead to long-term wage increases and it does not support the weakened housing market (higher oil prices take away money that could be spent on mortgages). Hoarding behavior also pulls demand from the future to spend in the present. That's got Ponzi written all over it.

I don't claim that I can think up a better system than capitalism, but I will say that capitalism has major problems.

If capitalism could automate and/or outsource each and every job tomorrow to increase profits then it would definitely do that. What would happen next? I suspect that we'd see a record number of people on food stamps and our prisons would be overflowing. Just a thought.

Stagflationary Mark said...


What we've seen over the last decade is rolling bubbles, and gold is the last of them.

But without government, oil does not get pumped, transported and refined, and brigands take your gold.

I agree. I am not anti-government. I wouldn't have the bulk of my net worth in TIPS if I was. I trust the government at least as much as I trust corporations.

I think gold is extremely overvalued, especially compared to aluminum which I consider to be a modern miracle. Aluminum lets us fly and the cans hold our beverages (at a mere $1 per pound).

I also think government serves a vital role. I shudder to think where we'd be now if there were no government regulations of any kind. Shudder!

I also agree that deflation is a serious risk. I just think that negative interest rate policies are the wrong way to get us back on track. They aren't just a weak subsitute for fiscal policy, but they are actually worse than doing nothing potentially. I do not believe that we can devalue our way back to prosperity.

We should have diverted the money to job creation ideas. This was a huge mistake and we're way too late. Unfortunately, I'm at a loss for what the job creation ideas are.

This probably wasn't it.

BadTux said...

Jerry, it's a bit of a loop. In a pre-fiat-currency era, generally discovering a new source of gold or silver created inflation when the nation that discovered it spent it, which then brought gold and silver out from under mattresses, which then caused further inflation. So traditionally, inflation caused inflation, strange as that sounds. Then the opposite happened when a speculative bubble burst -- gold and silver moved back under mattresses, which caused deflation, which caused *more* people to move their money under mattresses, until major parts of the economy were basically back on the barter system because there was so little actual currency circulating that it was relatively useless for the purpose of commerce. This relative state of depression continued until the next big gold or silver strike, which caused the inflation cycle to start up again. Wash, rinse, repeat, and you have the story of the U.S. economy prior to WW1. Which brings up a question -- what happened in WW1 that caused this cycle to change? I'll have to think about that. But my guess is that the economy became complicated enough as the industrial age took off that descending all the way back to a barter economy was no longer feasible because the majority of Americans were no longer subsistence farmers.

Now that we have a fiat money system, it works much the same, except that the Federal Reserve can print money and have the government spend it whenever necessary to prevent deflation. Well, at least theoretically. This depends upon cooperation between the Fed, Congress, and the President, cooperation which has been, let us say, lacking. Keynes proved that simply printing money at the zero bounds was not enough. It has to be spent in a way that creates economic activity -- in a way that creates jobs. Otherwise, it's just lumpy mattress stuffing.

Mark, I'll try to address your comments separately, but two things I want to note: 1) Capitalism clearly requires government intervention insofar as maintaining a stable money supply, otherwise it results in massive swings between inflation and deflation that interfere with the operation of the economy due to the descent into a barter economy at the end of the deflation swing, and 2) for all its fault, capitalism is the best system of economic organization that we humans have thus far devised, so as someone who is fundamentally conservative, I'd rather make sure it works than go into untested untried experiments, thank you very much.

- Badtux the Capitalist Penguin

Stagflationary Mark said...

By the way, I am sitting in long-term inflation protected treasuries that I fully intend to hold until maturity.

My girlfriend has been unemployed for 2+ years and is back in college to switch careers (to healthcare just like many others).

TIPS have minimal long-term deflation protection (guaranteed to get face value at maturity) but my girlfriend sure doesn't (and guess who is funding her).

These therefore aren't the words of a person praying for more deflation.

It is the debt that's killing capitalism and we have yet to reduce so much of a penny of it in real inflation adjusted terms since the crisis began. Clearly what we've been doing is not working (nor did I expect it to).

Jerry Critter said...

I think the economy is as much emotion as it is science.

Stagflationary Mark said...


It has to be spent in a way that creates economic activity -- in a way that creates jobs.

Yes! That's what we should have done. I would not have complained about that. Absolutely. Oil speculators (and basic necessity hoarders such as myself) are not creating many jobs though. Sigh.

I have no problem with government stepping in and using monetary policy to fix short-term cyclical problems. We should never have relied on it to fix long-term structural problems though. I don't believe the middle class American worker would want to see how much monetary inflation it would take to balance our trade with China. See the last chart in this post.

And lastly, I think the last picture found here has a lot to do with why commodities were no longer stuffed under mattresses. I think that was the basis of true prosperity. I am concerned that investors of today no longer fear its gargantuan size though. (I still do.)

Stagflationary Mark said...

Jerry Critter,

I think the economy is as much emotion as it is science.

You may be right. If the economy asks you if it looks fat in a dress, run!

Hahaha! :)

BadTux said...

Okay, Mark, now on to you. Please note that I of necessity simplify things somewhat for the comments section of a blog. This is not an economics textbook and I am limited to something like 4096 characters total by Blogger. I point that out simply because you've stumbled across one or two of my simplifications and think you've stumbled upon a flaw in my reasoning (or at least that's what it appears to be from my reasoning).

I must say that I find it amusing that you talk about savers, which as I've pointed out on my blog are actually lenders. I.e., fundamentally you are lending your money to a bank, then the bank is pooling the money lent to it and spreading it across thousands of borrowers. A bank is fundamentally a risk aggregation mechanism so that if a borrower defaults, you don't lose your entire nut. Or at least, if banks were acting as banks that's what would be the case.

Regarding inflation and debt, let's do a thought experiment here. Let's say that you're in a metropolitan area where 20% down is required to purchase a home. 50% of residents are homeowners. They can on average save $20K to buy a new home. How much is the average home in this area going to cost? Hint: $100K :). Now, Fannie/Freddie encourages buying homes with only 5% down. The average resident is still able to ave $20K to buy a new home. Hint: You just raised the amount of home this person can buy to $400K. What's that going to do to the price of homes in this area?!

So in general, debt causes inflation, not the other way around, because debt allows more money to chase the same amount of goods. Or does inflation cause debt? After all, if I've saved $20K and I want to buy a home in my local area, I *have* to borrow 95% of the cost of the home, not 80%, and thus take on more debt, otherwise I can't afford the home! We're in that virtuous(?) circle again where it's hard to tell cause and effect. Other than, well, an attempt to increase home ownership clearly had the opposite effect.

So: government actions making it easier to take on debt clearly had an effect on price inflation, which in turn feeds into monetary inflation due to the multiplier effect of fractional reserve lending as money moves out from bank reserves into the economy and increases the money multiplier. The question is what to do about the situation now. Deflation clearly is the wrong answer, since deflation is debt inflation, and if people are having trouble paying their debts *now*, deflation will be disasterous. Deleveraging appears necessary, but will be painful for someone. Bankers are determined it won't be *them* that pays for it, but that leaves the ordinary consumer on the hook -- and the ordinary consumer is the one that doesn't have the money anymore, now that they spent it on whatever they borrowed it to spend on, leaving banks to foreclose on houses they have to dump at 50% loss on value. Meanwhile we *could* inflate our way out of the situation (since monetary inflation is debt deflation), but that's causing *other* parties to scream in horror (and would not work if we allowed the consumers to take on more debt anyhow, we'd have to e.g. gradually ramp back to 20% down mortgages if we wanted to do that). The system has locked up, and I don't know what's going to get us out of it. Or as JzB is fond of saying, WASF.

- Badtux the Economics Penguin

Stagflationary Mark said...


Thanks for the detailed reply!

I love your mortgage analogy. That's kind of what turned me bearish in 2004. I came to think that we had a system where car dealers had convinced people that "what do you want your payments to be" was all that matters.

Unfortunately, the real world doesn't work that way. If people overpay for homes then more homes will be built. Eventually that mechanism has no choice but to implode.

In 2009 I even created a model that tried to duplicate it. I didn't use downpayments but I did use nominal interest rates (the data was easy to find). Since interest rates were generally falling, that meant that we could afford more expensive homes with the same payments.

Housing Price Simulation

Okay, so here's the premise of the computer simulation. Take 65% of the BLS average weekly wages and apply them to the cost of basic home ownership. I have assumed that 1.5% of the price of the home is needed to pay property taxes, insurance, and miscellaneous per year. The rest is used to pay principal and interest on a 30-year conventional mortgage. This is a "what do you want your payments to be" simulation, since that is the society we seem to live in.

If two people are working, that works out to about 1/3rd of all income. How did I come up with that number? It simply did a good job of helping the model match reality (in other words, the red line most closely matches the black line in the chart below).

Back to your comments.

The system has locked up, and I don't know what's going to get us out of it.

That's exactly where I am. I am very concerned that if I can't think up many new job creation ideas then maybe others can't either. We seem to be eliminating them faster than we create them and we're relying on unsustainable debt to bridge the gap. If true, that's very scary.

Stagflationary Mark said...

I should have said that I love your thought experiment (not analogy). I just had analogy on the brain because it made me think of car dealers.

Stagflationary Mark said...

Here's a bonus thought concerning job creation.

Jerry Critter said...

You save your money in a bank, or from another point of view, you "loan" your money to a bank. They, in turn, loan that money out. But they loan that money out to multiple people. In other words, you "loan" $10,000 to the bank, and they "loan" $10,000 out to several people, hence multiplying or inflating the value of the money. In the process, they skim a certain percentage of the top. So, they not only inflate the money, they reduce the money supply.

And they product nothing of value!

BadTux said...

Actually, it's easy enough to create jobs, if you think out of the box. For example, if we said "Fuggit, everybody between the age of 55 and 65, you can now retire with full Social Security payments" (and funded it with freshly-printed dollars buying Treasury bills), that would free up a huge number of job openings as the Boomers between age 55 and 65 suddenly leave the workforce, while increasing aggregate demand as Boomers saving in case they lose their job between age 55 and age 65 (since loss of a job between said ages means you're likely never to have a job again) suddenly have a huge load taken off their back.

And that's just one idea off the top of my head, I can come up with literally dozens of ideas that would create jobs for every unemployed American today, which in turn would result in increased aggregate spending and thus economic productivity. Remember, FDR created 4 million jobs with the stroke of a pen in November 1933, though I understand right-wingers think they weren't really jobs because working for the government is, apparently, slave labor as far as they're concerned. But what's not working is our political system, which has turned into a he-said she-said high school debate club squabble rather than a serious attempt to tackle the problems of our nation, facilitated by a media which would somberly report "opinions of the shape of the world differ" if the Republicans came out tomorrow and demanded an end to the teaching of that heretical round-earth theory (it's anti-Bible, y'know?).

And that, in the end, is why WASF -- not because government could not theoretically solve the current jobs and debt problems, but because *our* government cannot due to imperial incompetence, stupidity, and hubris.

- Badtux the Waddling Penguin

BadTux said...

Jerry, no, that's not how it works. Banks create money via the process of fractional reserve lending. Let's simplify this by assuming that Citibank is the only bank in America (i.e., treat the entire banking system as if they were one bank) and that there's one business (i.e., treat the whole marketplace as if it were a single entity). You loan your $10K to Citibank. They loan $8K to Joe Dork to buy a used Mustang. Joe Dork pays Sleazy Dealer $8K for the used Mustank. Sleazy Dealer deposits that $8K into his account at Citibank. Citibank loans $6K of that to Billy Bob who buys an old Chevy pickup truck from Sleazy Dealer. Sleazy Dealer deposits that $6K into his account at Citibank.

Note that right now, Sleazy Dealer has $14K in his bank account, even though the bank started out with only the $10K that you loaned it! It's the miracle of the loaves and fishes, $10K turned into $14K, glory hallaleujah amen! It is actually mathematically provable that as that money goes through the banking system and gets loaned out over and over again, the amount of money in people's accounts will be greater than the input was. If, for example, the reserve ratio is 20% (that is, if the bank gets $10K, they can loan out $8K), the eventual balance that will be in people's accounts will be $10K/.20 = $50,000. In short, banks create money when they lend. 5 times as much money as they started with, in this example!

Well, they do if there's inflation to encourage people to put their money into banks rather than leave it under mattresses, and if there's inflation to encourage banks to lend money rather than leave it stashed on account at the Federal Reserve. Which is sort of where we started with this post :).

- Badtux the Fishes and Loaves Penguin

Jerry Critter said...

"banks create money when they lend."

I think that is what I was saying...although maybe not as eloquently as you did.

BadTux said...

Okay, I think I might have misunderstood what you said, Jerry. But anyhow, banks *do* provide a service of use to the economy: that of risk aggregation. That is, rather than you loaning your $10K directly to Joe Dork and maybe losing all of it if Joe Dork goes bankrupt, you're at most risking a few dollars of interest if Joe Dork goes bankrupt because your money has been spread across thousands of loans to thousands of people.

Now, you can argue whether this service justifies the millions of dollars that the big banks pay their top executives (answer: No), or whether this service justifies banksters grifting a large percentage of the money going through them into their own pockets (answer: No) but you can't deny that this *is* a service. If we didn't have banks, we'd have to invent them, because otherwise capitalism just doesn't work.

- Badtux the Capitalist Penguin

Jazzbumpa said...

Geeze, youse guyzes. Turn my back for a few hours and rational discourse breaks out, What the hell is up with that?

Gotta go pick up grandaughters. Back at ya later with some comments.


nanute said...

I was thinking the same thing. I don't know how I missed this one. you've got some heavy hitters here, so I'll stand back and absorb all the insight for now. Where's Art?

Joe said...

An entertaining video of Tux's exposition:

JerseyCynic said...

I couldn't help but notice the only heavy hitter to make any gains yesterday was P & G and all their consumer gods -- I mean GOODS.

Does this mean there is still faith in the consumer?