THE BIG LIE II - GROWTH THROUGH BORROWING

I’d like to continue my Big Lie series with an even bigger lie than the one I talked about last time. This lie – generally (and unfairly) attributed to John Maynard Keynes – is the one that says a nation can stimulate economic growth through borrowing.

I need to be unequivocal on this. The notion that a nation can increase its standard of living by borrowing is completely and categorically false. It is not supported by history or logic.

First, let's be fair to Lord Keynes. Although his name is almost always mentioned in connection with deficit spending, he didn’t advocate it. What he said was that a nation can smooth out the effects of the business cycle by acting counter-cyclically. In other words, the ups and downs of the cycle can be mitigated if a government borrows and spends when times are bad and pays the money back (i.e., runs surpluses) when times are good.

And this is right. I agree. Governments can lessen the impact of a down cycle by spending. In that sense, I am a total Keynesian. But have you ever heard anyone quote Keynes to argue in favor of running surpluses? I haven’t. And my guess is, you haven't either.

But enough of Keynes. God knows, he’s received enough scholarly analysis already. What I want to talk about is the dynamics of borrowing, what it is, what it does to human beings, and what it does to the economy. First of all, we need to ask the fundamental question, what is borrowing?

Borrowing means using something I don’t own, right? I borrow your saw to cut some lumber. I borrow your shovel to get the snow off my driveway. I borrow a cup of sugar to bake a cake. No harm, no foul. Nothing wrong with that. As long as I get your permission to use the saw or the shovel or the sugar, and as long as I give it back.

Okay, so we know what borrowing is. The next question is, when I borrow something, where am I borrowing it from?  I don’t mean this in the sense of “Bob’s garage” or “Emily’s kitchen”. I mean it in the sense of,  “from what source or store of value”?

One answer might be, I am borrowing from someone else’s savings. At some time in the past, the person who bought the saw or the shovel or the sugar deferred the possibility of present consumption in order to “invest” in the things I am borrowing, and I am borrowing from those savings.

Another answer, equally correct, is, I am borrowing from my future consumption. In other words, by borrowing, I am incurring an obligation that will have to be repaid from resources that I am going to have to save, rather than consume, some time in the future.

Now, you may object that not all borrowing has this characteristic. For example, if I borrow a saw from you, I haven’t necessarily taken anything away from my future consumption. This may be true in some cases, but in general, the fact remains that if I borrow the saw, I have an obligation to return it in more or less the same condition. If I break the saw or damage it or wear it out –which I eventually will do if I keep borrowing it – I’ll have to replace the saw, and this will have to come out resources that could have been devoted to future consumption. (Admittedly, the point becomes clearer if I borrow the sugar or, say, a hundred dollars or two.)

So, in general, it’s fair to say that borrowing involves a shifting from future to present consumption or, in other words, a higher standard of living now, at the expense of a lower standard of living later.

Don’t get me wrong. There’s no value judgment implied in this. It’s a statement of fact. It may be entirely rational for me to borrow in order to meet a present need. But the idea that borrowing can increase my standard of living in the long run is preposterous. While my standard of living may apparently increase when I am in debt, it will decrease when I pay the debt back. In the long run, my standard of living will remain the same. In itself (i.e., ignoring the cost of interest) borrowing is standard-of-living neutral.

What’s true of me, is also true of a nation. In the long run, borrowing affects only the timing of consumption, not its quantity. It has no effect on the long term standard of living … ignoring the impact of interest.

But how can we do that? How can we ignore the impact of interest?  The answer is, we can't.

If you read the Bible (especially the Old Testament), you will see that the ancient Israelites took a very dim view of lending anything out at interest. The reason is never really stated, but a distinction is clearly made between lending as an act of generosity or kindness, which is considered good, and lending at interest, which is considered bad.

So, what’s the difference?

Again, the Bible doesn’t really say, but here’s my guess: The world is an uncertain place. Things don’t always go according to plan. Despite our best intentions, it’s sometimes impossible for us to meet our obligations. And the problem is, the debtor- creditor relationship doesn’t take this into account. If I borrow from you, end of story, I have to pay you back. If you’re my neighbor, I may have reason to hope you’ll make allowances. But if you’re my banker? If you’re my banker ... let's just say, at the first sign of trouble, you're gone. The friendly loan officer who was delighted to welcome me as a valued customer, extend me a line of credit and take me to lunch, is nowhere to be found. In his place is a “workout specialist” who calls me, my wife, my boss, my kids and anyone else he can think of to make my life a living hell.

Obviously, this situation does nothing for me psychologically. It raises my stress level. It damages my self esteem. It in no way helps me to relate harmoniously to my wife and family, to perform my work or, for that matter, to repay the loan. But as bad as it is for me, it’s probably even worse for the workout guy, who somehow has to find a way to deal with the guilt he feels, day in and day out, for the despicable things he has to do.

So there are very real psychological and spiritual costs to the institutionalization of debt that economists don’t consider in computing standard of living. But there are also important economic consequences that they do take into account.

The first – and obvious – consequence is that when debt is institutionalized and the debtor has to pay interest, the interest tends to make borrowing a worse deal than it would have been without the interest. And all governments – even governments like ours, with central banks that can print money to buy the debt and force down the interest rates – still have to pay interest when they borrow money. The negative impact of interest is exacerbated when nations borrow money from foreign sources, because the interest cost directly reduces the long term domestic standard of living. This is present the case in the U.S.

The second – and less obvious – consequence of interest is that its existence tends to increase the concentration of wealth; first, because the existence of interest increases the incentive for those with excess resources to hold onto them rather than spend them; and second, because it increases the amount of future consumption those with resource deficits (i.e., borrowers) have to give up when they repay the money.

Concentration of wealth has its own negative consequences, which are beyond the scope of this post. Perhaps we’ll deal with that in another installment of the Big Lie series.

But I think the next post will have to deal with inflation.

THE BIG LIE I - WORLD TRADE

There are a lot of big lies out there, but the one I want to talk about today is the lie that says a country can increase its standard of living by buying cheap stuff from places where the standard of living is lower. This lie is usually defended under the banner of “free trade”-- the benefits of which are taken to be well established and proven. Actually, this defense is bogus. Trade among nations with different standards of living ultimately has a leveling effect. The lower standard of living goes up, and the higher standard of living goes down.

The classical notion of free trade is that nations can benefit by concentrating on the production of goods with respect to which they have “comparative advantages”. The classic example -- given by David Ricardo -- is trade between England and Portugal. Since the cool, damp weather of England is hospitable to sheep, and the warm, dry weather of Portugal is hospitable to grapes, both England and Portugal will benefit if England produces wool and Portugal produces wine, compared with the situation in which both countries try to produce both commodities themselves.

In situations where nations have true “comparative advantages” – such as location, climate, or natural resources – this is no doubt true.  Both can benefit from expanding production of the product with respect wo which they have a comparative advantage  (forgetting, for the moment, the cost of transportation).

But what does any of this have to do with the modern world.  In particular, what does it have to do with China?

China is located nowhere near its primary export markets. Its climate is highly variable, and not particularly suited to the production of one thing or another. What’s more, China is notoriously poor in energy and many other natural resources. So what does it have going for it?

Well, despite several decades of Communist pretense, China does have a centuries-old tradition of trade. Just travel around Asia and you’ll see what I mean. Everywhere you go, there are Chinese (and Indian) traders descended from long lines of Chinese (and Indian) traders. Second, China has a command economy that can allocate capital quickly to take advantage or perceived opportunities. Third, China has an enormous pool of unemployed and underemployed workers who are used to an abysmally low standard of living.

All of these factors are necessary in explaining China’s recent economic ascent; none is sufficient standing alone. But it also needs to be pointed out that none of these factors – least of all a large pool of impoverished workers – can be called a “comparative advantage” in the classical sense. A “comparative advantage” in the classical sense is not diminished by its exploitation. England does not get less rainy by producing wool. Portugal does not get less sunny by producing wine. But a pool of impoverished workers? Over time, it will be diminished as people are put to work. As their standard of living rises, the “comparative advantage” of their poverty will be lost.

And what about the trading partners that have benefitted from that poverty?   Even assuming all else is equal -- that they have traded goods and services -- whether in raw materials, technology, or agricultural commodities -- of equal value, their benefit will be lost.  But to the extent these countries have run trade deficits with China,  their export has been debt. 

Debt is a promise to suffer a lower standard of living tomorrow in exchange for enjoying a higher standard of living now.

This is the trade the United States has been, and still is, engaging in.