Intro: The complex nature of the global economy can make it difficult to conceptualize how the economic system works. If we remove money from the equation and simplify the economy into a few sectors, it can help us understand fundamental economic principles such as: how and why savings drive economic growth; how interest rates allocate savings; how excessively low interest rates can cause recessions; the fallacy of demand driven growth; and how fiscal stimulus measures tend to be counterproductive.
In this economy there are just four economic variables:
- Farms, which use tractors and labour to create food.
- Tractor companies, which use labour to make tractors, which increase farm output.
- Labour, which can either work on farms of for property companies, but training is required.
- Food, which the owners of the farms and tractor companies pay their workers in lieu of money.
Both farm workers and tractor workers are paid in food. They consume some of it and save some of it. Farm owners rely on tractor company owners to get the machinery they need to increase farm output, while at the same time, tractor owners require farm owners to lend them food to sustain themselves while they produce tractors. In return for the food they borrow, tractor owners agree to deliver tractors to the farmers when they are completed.
The Importance of Savings in Enabling Economic Growth
The more of their food that farm workers save, the more that is available for tractor owners to increase tractor production and thus ultimately boost food output. If farm workers do not save any of their wages, there will be no food left over for tractor owners to sustain their workers while they make tractors, thus no tractors will get produced and less food will be produced in the future. The more we eat today, the less we eat in the future, and vice versa.
The Role of Interest Rates in Capital Allocation
Of course, farm workers will not just lend their saved food to tractor owners interest free. They must be compensated by the expectation of getting more food in the future. The interest rate at which they are willing to lend food depends on the rate at which they prefer food now to in the future. If they are relatively frugal and are happy to save food, then the interest rate at which they lend it will be low (high supply of savings equals low price of borrowing those savings).
Let’s say that savings rates are high and farm workers are willing to lend 100kg of wheat in return for 101kg of wheat in a year’s time, equating to an interest rate of 1%. Even without knowing with their own eyes there is an abundance of saved food, the low interest rate will signal to tractor owners that there is an abundance of food available to borrow. As a result, tractor owners will tend to be able to embark on the production of very complex and productive tractors that take a long time to build, because they can feed their workers for a long period of time knowing that when they will not accrue large interest costs.
They will also demand more labour, and to attract workers to shift from working on farms to working making tractors, they will have to pay more food to their workers. This in turn will result in a boom in tractor production and allow greater production of food in the future. For consumers this works out perfectly. The more food they set aside now, the more they are able to consume in the future.
On the contrary, if there is a lack of willingness to save food in the present, farm workers will only be willing to lend the food out at high interest rates. Again, even though tractor owners do not know that there is a lack of available food savings, the high interest rate does this job for them. This will signal to tractor owners that they should not embark on lengthy tractor-building projects because the interest burden will be too high. So instead they build smaller, less productive tracts, with fewer workers, and as a result we do not get much of an increase in food production.
The paradox of thrift, or fear over an increase in savings, reflected in policymakers’ desires to increase consumption, fails to take into account that the economy as a whole doesn’t suffer when consumption falls. Instead, consumer-focussed sectors of the economy suffer, while investment sectors benefit. And over time, the consumer sectors also benefit because the amount of food grows.
How Excessively Low Interest Rates Can Cause Recessions
What the above shows is that the interest rate, far from being an abstract financial market variable, is the vehicle that allocates capital based on intertemporal consumption preferences. However, what if the interest rate for borrowing food is set by an external force rather than by the free market?
Let’s assume workers want to save very little, and therefore interest rates should be relatively high, but the central bank is not omnipotent and errs in setting interest rates too low. Tractor owners will effectively be fooled by the low interest rates into thinking that there is an abundance of food available to sustain them as they build their tractors, so they embark on very complex tractor production processes and draw large amounts of workers into the industry.
Initially, there is no problem. Each month the food loans come and the workers are sustained as they build the parts for a series of complex and highly productive fleet of tractors. However, over time, problems arise as the availability of food diminishes before the tractors are built. What results is a series of tractors that cannot be completed, and the resources are effectively wasted.
This is a recession. Capital goods output collapses as no new tractors are produced, and the lack of ability of tractor owners to pay their workers results in a shift of labour back towards farming. The process is not smooth and it takes time for workers to retrain to become farmers. But it is ultimately what is needed to restore production in line with consumer preferences and the availability of resources (in this case food) in the economy.
The Fallacy of a ‘Lack Of Demand’
While economists tend to conclude that recessions (or slow growth) result from a lack of demand, when looking at an economy in terms of barter it becomes clear that this cannot be the case. The recession did not occur because farm owners did not demand tractors, not because workers did not want food. The recession occurred because of the mismatch between what consumers demanded and what producers were trying to produce, due to distortions in interest rate signals by the central bank.
The Problem with Fiscal Stimulus
During the recession, when workers shift back to farming and away from producing tractors, there is an inevitable adjustment period that must take place where farm owners must take time to retrain workers and adjust their operations to the new abundance of labour. Unemployment rises as this healing process takes place.
No government wants to sit idle while there are large numbers of unemployed workers. They feel the need to “do something”. There are a lot of unemployed tractor workers who can’t be easily trained to be farmers in the near term. So the government decides to hire these workers to build tractors to ensure overall output stays unchanged and there is no unemployment. This is positive for ‘GDP growth’ in the near term but it continues to perpetuate the imbalance between the resources available and the goods that are being produced.
However, the reality of the situation is there is not enough food to go around, so when the government hires workers to continue making tractors, they must somehow take the food from farm workers to pay the wages of tractor workers. In practice they either do this directly by taxation or indirectly by creating IOUs to buy the food off them (Quantitative Easing). Over time, the amount of food available to sustain tractor production diminishes further. The more the government prevents a re-alignment of resources with consumer demands, the more the ultimate correction will have to be.