The World Deserves a Pay Raise

We have all been raised to believe that money is very valuable. The intuition we build about this during our daily interactions with money confuses us about the effect it has on the economy as a whole, what macro-economists call the “aggregate”. On the aggregate, money doesn’t have any real intrinsic value. It’s just paper, it’s coupons, it’s IOUs and people accumulating it adds zero to the overall wealth of society.

In the past decade, wages have been stagnating, unemployment has been high for long periods of time, taxes have been going up and debt relative to GDP has been going up, setting everyone up for more of the same. All this, at a time when we should collectively have been accumulating a surplus while increasing investment in government and business infrastructure to prepare to support a large retiring cohort.

Millennials have been facing a difficult entry into the workforce. People living in regions without natural economic advantages, such as those living outside of urban centers have been disproportionately affected.

Things have also been difficult for savers who have been getting low returns while at the same time facing rising future taxes on their savings because of the growing government debt.

There is evidence that overly tight central bank stances has been the most important factor in all of this.

Even though it can seem abstract, the harm to people’s lives of mismanaging the monetary system is very real.

Central banks tightening pushes up interest rates on money which means savers get paid to not invest, to not create jobs and to hold on to government paper instead. When central banks have too tight a stance, this shields savings from having to be negotiated on private markets. It allows the wealthy to hold on to money, to hold on to government coupons as claims on future output without having to fund productive endeavors and projects. They get to simply hold government enforced promises at above market rates.

In an overly tight monetary environment, cash and government bonds basically become a government created subsidized wealth haven. Why would wealth holders put their money on the line and hire people when central banks are giving them an artificial store of value that retains wealth at above market rates?

A disproportionate part of people’s savings become detached from physical economic activity and are only tied to government paper.

When government offerings to savers are unfairly advantageous, people, businesses and banks turn to, on a vast scale, holding on to government paper instead of doing private investment. We see accumulations of excess reserves, banks not lending, businesses and governments holding on to cash instead of starting new projects.

Central banks set the critical rates that are supposed to make savings flow to investment and they are not allowing this to happen sufficiently. Interest rates, can seem low but even hovering around zero, they are often still above market rates, otherwise government paper wouldn’t be hoarded so much. For example, Ben Bernanke estimated that rates in line with markets should have been as low as -4% in 2009.

It’s sometimes easier to reason about the aggregate economy by thinking about simpler agrarian societies.

Imagine an isolated village where people farm for subsistence. This is a village disconnected from the world that has not had a currency up to now. People rely on barter instead. Every fall, villagers usually produce excess food to have something to eat in the winter, even if, the real returns on the investment is low. Because of spoilage, crops stored for the winter are only worth 90% of their usual real value. 10% rot away in storage. That is, these crops have a return of negative 10%.

One day, this village mandates its government to create a currency that always keeps 98% of its real value on a yearly basis (2% inflation) even during times when private savings assets can’t retain this much. The government puts money into circulation by buying part of farmer’s crop during the summer (civil servants have to to eat).

Most farmers produce enough food for the summer, sell some of their crop and keep their money to be able to buy something to eat in the winter. They do not produce a crop to store for the winter since it would only return -10% on their initial investment and the central bank promised money would keep value at a rate of at least -2% (plus maybe a bit of interests).

What happens when winter comes? People have cash but few have anything to sell because they didn’t reinvest in the production of a crop to be stored!

In this situation, it’s going to be very difficult for the government to control inflation because there will be too few goods for the amount of money people will want to spend.

If the government does manage to control inflation, it will be through high taxes or by depressing the nominal value of the crops of the few farmers who did store something for the winter. The central bank might do this by giving high enough interests payments on cash to prevent people from wanting to spend it immediately.

In any case, people won’t eat much during the winter because the food will simply not exist.

The point is, government money can easily jam markets and crowd out productive investment.

This dire situation could have been easily prevented if the central bank had kept money devaluating sufficiently (in this extreme case, inflation above 10% in order to keep real interest rates at -10%). Farmers would not have kept most of their savings as idle cash but would have reinvested them into an extra crop stored for the winter and have continued to trade during the winter.

Farmers would not have accepted as much money from the central bank and would have instead lent and paid each other for work. A small amount of base money would have been multiplied into a larger money supply and the resulting transactions would have allowed the necessary winter crops to be produced and the ratio of real stuff to financial promises to stay reasonable.

There are parallels with farmers saving for the winter and a baby boom saving in preparation for retiring and stopping to work.

Central banks that allow money to retain too much value, are doing like in the village example, they are encouraging savers to keep pieces of paper as a claim on future wealth without anyone necessarily investing in the infrastructure and capacity to produce this future wealth. People that should have been building inventory, infrastructure, new technologies or production capacity remain unemployed instead.

Other ways to resolve this type of situation include wage adjustments, temporarily reducing farmers expectations of how much they immediately get for their work (but allowing them to get more overall). This could actually happen in a simple economy like above but in a complex economy wages are sticky, there are coordination issues that prevent them adjusting even when there are people on board for the adjustment (and often times there are not many).

Few people want to be the first to adjust their wages downwards to save jobs, but even when some are willing (maybe because the risk of ending up unemployed looks high to them), it might not help much since to be able to save their job without bearing too concentrated a burden and lowering their wages excessively, not only does their own wages have to go down, but their colleagues’ have to go down, their employer’s suppliers’ employees wages have to go down, the suppliers’ suppliers’ as well as people down the chain, the salespeople etc.

In a market suffering from the effect of generalized too low prices, the whole supply chain may have to drop wages in a synchronized manner for the burden to be spread broadly enough to have a realistic chance at saving businesses. It’s a coordination problem. I don’t think we can expect this to happen very smoothly without central bank help.

And since the chances of saving businesses may be low, the rational action for an individual unable to save his or her job might be to take a hard stance on wages and try to extract the most out of the employer before becoming unemployed. That is, above market, job destroying wages can be a Nash equilibrium.

An alternative solution to the problem in the scenario above is the government buying a crop and storing it in order to distribute it in the winter. This is the government fiscal approach. This can work if the government has the foresight to invest efficiently in projects having the correct maturity time frame. However, it might be difficult for the government to do when interest rates are kept above equilibrium by central banks as this skews cost-benefit analysis and forecasts. Plus if government spending raises inflation, this may cause central banks to tighten and offset fiscal efforts. This means that the government fiscal approach might not work unless central banks are also doing their part and targeting high enough inflation.

—

Some people say that negative real returns are always unnatural in private markets, that money that is losing value could never be a threat to good private investment and that investment with lower returns should simply not be made. These people often use the word “malinvestment”.

This is easily refuted by pointing out that historically, negative real returns on stores of value were the norm. Before financial systems existed, almost all investments had negative returns if you didn’t put work and energy into them. To store value, you had to accumulate stuff, buildings or land. Most options either had high maintenance costs, were subject to risk of damage from natural causes and theft, were very volatile or required hard labor to get production out of.

Even in societies with financial systems, getting low risk, hassle free, liquid, positive real returns has been difficult for most of history. This just reflects the natural laws of thermodynamics that tell us that everything tends to decay without a constant supply of work and energy. In general, most things require maintenance to keep their worth.

The 20th century was probably the most notable exception. Because of unprecedented demographic and technological growth, positive risk free real returns were easy to find. The recency effect probably explains some of the confusion people have about this. It is possible that under favorable conditions, wealth can have positive returns and even compound into very good long run returns but it is not a guarantee and there is nothing natural about it. It may not continue forever, particularly amidst an aging and retiring population in a world no longer as rich in easy to exploit natural resources.

While people are used to get negative returns on very short term purchases, you buy fresh vegetables at the supermarket, even if they degrade over time, many can’t seem to accept the normalcy of negative returns on longer term assets. In nature, squirrels’ nut caches have a certain percentage of losses from theft and spoilage. Real returns tending towards the negative is natural even if they can seem unusual for humans just out of the 20th century.

—

Here is another way to see it: Keeping central banks sufficiently accommodative puts savers in a position where their most advantageous means of maintaining their wealth is to rely on real economic activity. The act of saving and investing is like saying to others: Here, take this money and use it to buy some tools, build some factories, work, support yourself and give us some of the product of this work in exchange.

On the other hand, keeping money too tight is making it advantageous to savers to instead proclaim: We will hold on to these pieces of paper as a claim on other people’s future wealth but won’t help finance the tools and infrastructure needed to generate this wealth, and if, even without proper tools, people manage to pull themselves by their bootstraps and create good value, we will use our overvalued paper to claim some of it at a discount. Is it a wonder few want to create new businesses and new jobs in this environment?

It is incredibly damaging as it prevents people from helping themselves. Even for those that do manage to lift themselves by their bootstraps, even for the employers that take the risk and hire in vulnerable regions against the odds, there will be piles of overvalued money on the sidelines waiting to claim an oversized share of their production at a discount. The future prices that they will get for their work and investment will be suppressed if governments keep money too tight.

To put it another way: In a situation of too tight money, if you or your friends are unemployed or underemployed it is likely because central banks are effectively allowing wealthy people to hold subsidized claims on the fruit of your future labor in order to stop them from investing in job creating activities right now. Money is a form of debt, it is an implicit promise from those who don’t have it to those who have it. Money that overly retains value is indirectly making you, the unemployed person, promise to support wealthy people’s future spending so that they don’t have to be involved right now in risk and real economic activity to store their wealth. You are effectively going to pay this subsidy in the future when you are better employed. Central banks are making your future self pay to destroy your current job.

Its hard to know how the future burden from too tight money gets paid. It could be future taxes, future asset depreciation or uncontrolled inflation. There is an interplay between government debt and central bank actions that makes it difficult to predict. But one thing is sure, if a global buildup in paper savings isn’t matched by a physical buildup in capacity and a rise in future availability of things to buy, if there comes a time when people want to reduce work and redeem their savings, since the capacity won’t have been built and labor will be less available, the only way for the promises inherent in those savings to be fulfilled will be through forced redistribution from the finally better employed to holders of financial paper.

This is all at a great cost to everybody. Almost no one gains. The rich lose, the poor lose even more. And it’s done out of misguided fear that too many people having good careers would create slightly more inflation than central banks want.

It’s no wonder that people are becoming more angry. If they understood they were being forced to fund the destruction of their own jobs, I’m not sure there wouldn’t be an outright insurgency.

Artificially tight money not only jams the private sector. Governments too make spending decisions that are skewed by tight money and they are constrained by lack of revenues caused by high unemployment.

If you are a citizen not in the urban heart of the economy, someone rural, inexperienced or your personal context puts you in a disadvantaged economic extremity, you probably have near zero political power to change how central banks operate, yet you are the most affected by their actions because margins are thin for jobs available to you and these are the first jobs that disappear. If central banks are not acting competently, you are forced to watch as funding for tools and business infrastructure is sucked out of your area and jobs disappear.

I hope this helps to understand the situation. If you want arguments from a real economist with supporting data, read David Beckworth’s blog ( http://macromarketmusings.blogspot.com/ ).