Obama Placing the Economic Cart Before the Horse

In his first televised speech before Congress, President Obama asserted that prosperity will return once the government restores the flow of credit in the economy. It may come as a surprise to him, but an economy cannot run on consumer loans. Furthermore, credit stopped flowing in the U.S. for a very good reason: there was no more savings left to loan. Government efforts to simply make credit available, without rebuilding productive capacity or increasing savings, are doomed to destroy what's left of our economy.

The central tenets of Obamanomics appear to be that access to credit will enable people to borrow money to buy stuff, the spending will spur production and employment, and thus the economy will grow. It's a neat and simple picture, but it has nothing whatsoever to do with how an economy works. The President does not understand that consumption is made possible by production and that credit is made possible by savings. The size and complexity of modern economies has obscured these simple concepts, but reducing the picture to a small scale can help clear away the fog.

Suppose there is a very small barter-based economy consisting of only three individuals: a butcher, a baker, and a candlestick maker. If the candlestick maker wants bread or steak, he makes candlesticks and trades. The candlestick maker always wants food, but his demand can only be satisfied if he makes candlesticks, without which he goes hungry. The mere fact that he desires bread and steak is meaningless.

Enter the magic wand of credit, which many now assume can take the place of production. Suppose the butcher has managed to produce an excess amount of steak and has more than he needs on a daily basis. Knowing this, the candlestick maker asks to borrow a steak from the butcher to trade to the baker for bread. For this transaction to take place the butcher must first have produced steaks which he did not consume (savings). He then loans his savings to the candlestick maker, who issues the butcher a note promising to repay his debt in candlesticks.

In this instance, it was the butcher's production of steak that enabled the candlestick maker to buy bread, which also had to be produced. The fact that the candlestick maker had access to credit did not increase demand or bolster the economy. In fact, by using credit to buy instead of candlesticks, the economy now has fewer candlesticks, and the butcher now has fewer steaks with which to buy bread himself. What has happened is that through savings, the butcher has loaned his purchasing power, created by his production, to the candlestick maker, who used it to buy bread.

Similarly, the candlestick maker could have offered “IOU candlesticks” directly to the baker. Again, the transaction could only be successful if the baker actually baked bread that he did not consume himself and was therefore able to loan his savings to the candlestick maker. Since he loaned his bread to the candlestick maker, he no longer has that bread himself to trade for steak.

The existence of credit in no way increases aggregate consumption within this community, it merely temporarily alters the way consumption is distributed. The only way for aggregate consumption to increase is for the production of candlesticks, steak, and bread to increase.

One way credit could be used to grow this economy would be for the candlestick maker to borrow bread and steak for sustenance while he improves the productive capacity of his candlestick-making equipment. If successful, he could repay his loans with interest out of his increased production, and all would benefit from greater productivity. In this case the under-consumption of the butcher and baker led to the accumulation of savings, which were then loaned to the candlestick maker to finance capital investments. Had the butcher and baker consumed all their production, no savings would have been accumulated, and no credit would have been available to the candlestick maker, depriving society of the increased productivity that would have followed.

On the other hand, had the candlestick maker merely borrowed bread and steak to sustain himself while taking a vacation from candlestick making, society would gain nothing, and there would be a good chance the candlestick maker would default on the loan. In this case, the extension of consumer credit squanders savings which are now no longer available to finance other capital investments.

What would happen if a natural disaster destroyed all the equipment used to make candlesticks, bread and steak? Confronted with dangerous shortages of food and lighting, Barack Obama would offer to stimulate the economy by handing out pieces of paper called money and guaranteeing loans to whomever wants to consume. What good would the money do? Would these pieces of paper or loans make goods magically appear?

The mere introduction of paper money into this economy only increases the ability of the butcher, baker, and candlestick maker to bid up prices (measured in money, not trade goods) once goods are actually produced again. The only way to restore actual prosperity is to repair the destroyed equipment and start producing again.

The sad truth is that the productive capacity of the American economy is now largely in tatters. Our industrial economy has been replaced by a reliance on health care, financial services and government spending. Introducing freer flowing credit and more printed money into such a system will do nothing except spark inflation. We need to get back to the basics of production. It won't be easy, but it will work.

President Obama would have us believe that we can all spend the day relaxing in a tub while his printing press does all the work for us. The problem comes when you get out of the tub to go to dinner and the only thing on your plate is an IOU for steak.

Comments

[Carlos Lam:]

On Mar 02 02:44 PM manya05 wrote:

> But let me make my position very clear: 1) Obama did not create this
> mess, the Republicans did,

Wrong. The REAL culprits behind this foolishness are Democratic Pres. Woodrow Wilson and the Democrats in the U.S. House in 1913, led by Speaker Champ Clark. They shepherded through the Federal Reserve Act, which created the Fed. The Fed, in turn, has undermined our currency and caused untold moral hazards.

> We need a real change of direction here, if not Obama, who?

Two words: Ron Paul. He's the only one who has championed fundamental change, including the abolition of the Fed and an end to fractional reserve banking. Mike Huckabee gets an honorable mention for wanting to move us away from a production-based taxes (the income tax) to a consumption based tax (Fair Tax).

Mar 02 09:36 PM

[Carlos Lam:]

On Mar 02 06:00 PM CJJ wrote:

> Peter's ideas are to return to do nothing, return to the dark ages
> where people dote around gold in cloth bags, or wheelbarrows if you
> are richer.

I disagree. Peter's ideas are a return to the 19th Century when America produced things, leveled low taxes, and had very little regulation on those who risked their sweat and capital.

> What he fails to describe is the social unrest his ideas will result
> in long before resulting in any positive uptick in production.<br/>

Yes, those who rely on government to take from the producers will certainly riot. The producers among us should certainly be ready with 00 buck shot just in case.

> Peter is rooting for anarchy, glad so many of you just blindly agree
> to his ideas. His dad is in jail because he refuses to pay taxes.
> He'd rather see Somalia instead of the US. Let's all agree the US
> is a different planet than Somalia.

Peter is not an anarchist, not even an anarcho-capitalist; he's a follower of the Austrian School of economics. Many of us agree with Peter because we have read Mises, Hayek, and Rothbard or because we have observed the fiat money system and the problems it has caused; we do not "blindly agree" with Peter. Moreover, in America we do not punish children for the sins of their parents, so Irwin Schiff's position -- regardless of what it is -- is irrelevant. I'd note, however, that Irwin Schiff is at least willing to go to prison for his beliefs; that does show a type of moral courage.

Mar 02 09:44 PM

[O-B-WON:]

clam75

I wish I could give you a thousand plus thumbs up...!

Mar 02 09:46 PM

[timwalsh300:]

Clam,

I believe in individual liberty, not conspiracy theories. I think for myself instead of just regurgitating the talking points from organizations like Mises or people like Peter Schiff. If you believe in freedom, you should try independent thought. Read Mises, read Schiff, but read everything else too (Friedman, Keynes, Eisner, Krugman, etc.) and decide for yourself what makes sense and whose theories match the empirical historical evidence. Anyone who believes that one party/person/school-of... is always correct and flatly rejects everything else is a sheep.

The myths about the Federal Reserve peddled by so many people in the libertarian community have been debunked many times over. At this point it is an embarrassment and part of the reason we cannot get traction in the mainstream.

Mar 02 09:49 PM

[Steven Hansen:]

Peter, another great article. You forgot to tax at the highest rate the butcher, the baker or the candlestick maker to punish him for being successful.

Mar 03 12:29 AM

[Carlos Lam:]

On Mar 02 09:49 PM timwalsh300 wrote:

> you should try independent thought. Read Mises, read
> Schiff, but read everything else too (Friedman, Keynes, Eisner, Krugman,
> etc.) and decide for yourself what makes sense and whose theories
> match the empirical historical evidence.

I have. The Austrian explanation is the one that best makes sense. Keyensianism and Krugmanism were tried in the 1930s in America and 1990s in Japan. Neither worked. More philosophically, both rely on central planning. I firmly believe that no man, woman, or committee can take into account all the moving parts of an economy. Thus, my view is that central planning simply cannot deliver on its promises. Monetarism (Friedman) suffers from an equally problematic philosophical fault: it relies on central planning by the setting of interest rates.

If you believe in central planning, whether it be Keyensianism, monetarism, fascism or socialism, just say so. It just means that you and I will have a fundamental difference of opinion.

> The myths about the Federal Reserve peddled by so many people in
> the libertarian community have been debunked many times over.

1. Which "myths" are you talking about?"
2. How exactly have they been "debunked?"

Mar 03 06:02 AM

[User 365198:]

The author is correct in his assertion that in order to increase long run economic growth a country must increase the productive capacity of the economy or increase the employment rate. However, most economists now believe the economy is operating well below potential GDP. In other words, they believe there is excess slack in the economy due to productive capacity that is not currently being utilized. That is the idea behind any fiscal policy. The government wants to increase spending in areas with excess capicity in order to utilize the capacity and reduce the unemployment rate and improve the standard of living for people in the short run. Now it is another debate entirely whether they can do this more efficiently than the free market. Many economists will argue that long run effects of any fiscal stimulus are only nominal. However, to the extent there is spillover and an increase in aggregate demand for goods and services creates confidence among investors and consumers, this can lead to increased investment in the capital stock and thus increased productive capacity for the economy. The president is also investing money in infrastructure such as energy projects which should increase the productive capacity of the economy directly. I do not believe in this fiscal policy more because I question the governments ability to allocate resources more efficiently than a free market. However, I do not believe this authors arguement against fiscal stimulus is valid because it is not addressing the true purpose of fiscal stimulus.

Mar 03 09:17 AM

[Obamitall:]

You are right about the article being simple and concise, but some of the dummies do not understand. Probably never produced anything tangible.


On Mar 02 10:34 AM fatcat wrote:

> A simple,but concise explanation,even a dummy could understand.<br/>
>
> The powers in DC know how it works...they are just waiting for hyper-inflation
> to level the playing field...so they think..

Mar 03 09:27 AM

[timwalsh300:]

Clam,

Milton Friedman, considered the quintessential classical liberal and father of modern free-market capitalism, said himself that core tenets of Austrian economics were "contradicted by the evidence." I agree with Friedman's idea of monetarism, and I think it would be a very bold statement on your part to suggest that Friedman was anything less than a champion of freedom.

The beauty of fiat money and monetarism is that they offer elegant, free-market solutions to the problems inherent to a hard currency (i.e. gold). Monetarism is not central planning. Ultimately we, the people, control the size of the money supply - not shadowy figures at the Fed or in government. In fact, this is the root of Friedman's own dislike of the Federal Reserve. He believed that a good central bank just implements an algorithm, and that could be done by a computer. His concern was the potential for human error in carrying out monetary policy. With a hard currency and no central bank, our "monetary policy" would effectively be controlled by people beyond our borders. That is not my idea of freedom and sovereignty.

The Federal Reserve myths that I'm referring to are described here:
www.publiceye.org/cons...
home.hiwaay.net/~becraft/FRS-myth.htm
The burden of proof is on those who make claims of wrong-doing. I have seen no substantial evidence proving that the Fed operates in any manner other than the manner described in these links, or in classrooms of higher education all across the world.

Mar 03 09:28 AM

[Ferdinand E...:]

This is an interesting attempt to simplify and explain a difficult economic situation. It looks good but unfortunately it is insufficient, and maybe even wrong. It is not applicable. It does not explain the importance of credit and why it is essential that it is available.

Incidentally Timwalsh300, Friedman's idea of replacing a central bank by a computer is strictly off the wall. As nutty as an idea can be.

Mar 03 09:42 AM

[Depressedal...:]

And guess what political party has had control of the House and Senate for the majority of the time....you guessed it!! The spend-a-holic, socialistic Democratic Party! I am amazed at the "gullibility" of the populace who let "hope" replace reasoning. LBJ and his social welfare programs only added millions to the US Deficit. No political party has more of a historical record of wasteful spending, called "pork" projects, then the Democrats who have had control over BOTH houses since Franklin Delano Roosevelt. And since FDR have through their reckless political agenda/monetary policies have done more damage to the US economy. Throughout the years that they controlled both houses, they, the Democratic Party has not in any form/fashion tried to balance the budget or enact a responsible fiscal policy/budget for the United States. Senate/House voting records support this as a fact and history as always will repeat itself. Unbridled greed and the "fudging" of economic data along with the manipulation of financial instruments will be the undoing of the US and world economies as we once knew. Stability as we know now, in every form and fashion will be the "sacrificial victim" to the Fed's printing press and hyperinflation!!


On Mar 02 02:44 PM manya05 wrote:

> If the economy were such a simple system as a three-body trading
> problem, the basic principles would be obvious and we would all be
> geniuses. So, I do not think this is particularly a good article.
> But let me make my position very clear: 1) Obama did not create this
> mess, the Republicans did, 2) Obama IS screwing up the opportunity
> of his lifetime to really enact change and lead the country and the
> economy in a new direction, instead, he surrounded himself by also-rans
> invested in the system who cannot see beyond their feet. They (Obama
> included) think that by doing more of the same that got us here,
> we will get out of it. Maybe so, but for how long? We need a real
> change of direction here, if not Obama, who?

Mar 03 10:03 AM

[CJJ:]

Clam,
Can you please tell me what people are going to be working on producing when the people of the world become resigned to saving 33%+ of their income waiting around for death?
Can you please explain to me how well lax regulations on morgates worked out?
You continually point to letting people make up their own mind and everything will work out fine.

Here's an example: On drug addicts in the US. We spend billions of dollars a year to fight the illegal drugs. Billions of dollars a year to try and save drug addicts. And drug addicts drain and cause billions of dollars a year due to crime, medical issues, etc.
Most drug addicts are not going to get over the addiction with any amount of help.
So does that mean you do not help them?
So does that mean you make drugs legal?
So does that mean you kill drug users?

Each of these options has its pros and cons. Each has costs. None is an overall profit making endeavour. And none solves the overall problem, a problem which can't be solved.

Austrian economics doesn't have all the answers and many of the answers it lacks are just plain ignored by its champions. One main issue is like other economic ideals it doesn't prepare for downturns.

I'm not applauding one economic idea over another or vice versa, but blindly assuming that if people save, don't buy, there is no regulation and less taxes that all of a sudden productivity will magically appear is questionable. Once an Austrian economists can describe what exact jobs the billions of people in the world will have when they decry consumption, maybe I can take them more seriously.

Mar 03 02:56 PM

[billddrummer:]

Well done article, and it's similar to people who think they can borrow (restructure) their way out of debt.

Not only is that impossible, but after restructuring, you have even more debt.

The only way to get out of debt is to repay it. It's distasteful and limiting, but only until it's repaid. Then, it's liberating.

Now, if inflation resurfaces, there will be people urging us to borrow as much as we can, because our repayment will be in cheaper dollars.

But the credit bubble is what got us here in the first place, so how will more credit fix what went wrong to begin with?

Mar 03 03:06 PM

[fireball:]

hard work, saving, refusing to borrow worked well for me. now my money works for me instead of me working for it.
however in the new socialist economy i am halting all productivity. i will not be punished by taxation that is ridiculous for being frugal, responsible, and doing without until i could afford it.
let the collective pay for the socialism they want. i will not do it. i do not wish to sit in prison so i have retired until circumstances encourage me to become productive.
no politician made one penny of what i have earned. i am tired of contributing to garbage that is outside the constitutional limitations. invest in my country? i was but now punitive taxation says why risk it. contribute to society? i did, same problem. i have noticed a few other posters are quitting too. this is my peaceful resistance.
punishing the productive will get more of this reaction i believe. now my brothers are considering the same course as is my closest friend. this morning my older brother went to employee parking and counted the obama stickers on the cars. at noon he called and agreed that i was correct. let obahahahmahahah give them what they voted for.
socialism works until you run out of other people's money.

Mar 03 06:38 PM

[pfiddy:]

This claim that growth is required for economic survival gets glossed over as self-evident common knowledge all the time, and yet I've never heard anyone make any kind of convincing argument to support it. I think this goes hand in hand with the ludicrous-in-hindsight "axiom" about the stock market always going up (never mind that it went down in the past, because Things Are Different Now). Just because the only economic environment we've ever personally experienced within our lifetimes has been one that rewards reckless expansion and growth (and consequently consumption) for its own sake *does not mean* that this is a basic principle of economics in general. In fact, I'd argue that the reason what's going on now came as such a surprise to so many of us has to do with the fact that we've mistakenly believed this "expertise" about growth always being a positive and necessary thing. Once you throw out that axiom and reevaluate, things get a lot simpler to understand. You can simply apply all the intuition you have about how everything else in the world works...because now "the economy" is no longer a magical place free from the constraints of the second law of thermodynamics, the law of conservation of energy / mass, the what-goes-up-must-come... principle, and that whole thing about how those who cannot remember history are doomed to repeat it.

On Mar 02 11:13 AM Dirk McCoy wrote:

> The only way out of this is to realize that global growth is required, because you're either growing, or dying.

Mar 04 03:01 PM

[Bruce Pile:]

Peter, your simplified "thought experiments" illustrate the basic root problems so well. I especially like the one in your book about the American and others from various parts of the world trapped on an island and each assigned a job with the American's job being eating.

If you look at the charts of total debt history and the S&P 500, you see that the inflation of stock values that began in the late '80s correlates well with the take off of debt to the moon at about the same time, when all the fancy debt products were being invented to replace actually making things. It was a little like a Madoff Ponzi scheme full of air. When the air is all out, we will settle into the kind of flat, dull stock market we had from '66 to '82, a secular bear market when adjusted for inflation, before our whiz kids, far removed from any appreciation of the Depression, learned some tricks to liven up our life style.

You could explain these thought experiments to each and every individual in Washington, but I suspect it's something they vaguely already know, perhaps too vaguely. They just feel it would be too much of a ruckus to change it to the way it should be now, and they, of course, have to get reelected.

Mar 04 10:32 PM

[Just Say Whoa!:]

>Keyensianism and Krugmanism were tried in the 1930s in America and 1990s in Japan. Neither worked...

So, we're all still living in Hoovervilles in The Great Depression?

Or perhaps the massive Keyensian spending of WWII worked to pull us up out of the hole dug by Hoover, et. al?

You can't have it both ways. Either Keynesian spending FAILED and we never exited The Great Depression or it WORKED.

Mar 09 04:38 PM

[samwise:]

forget about the moving parts of an "economy." Have any of you actually worked for the government? Ever? The Polity itself is enormous and makes "economics" as simply a "concept" or "idea" as inconsequential. Turns out "economics" in its simplest form is the perennial straw that breaks the camel's back. Graduated from a public school, went to a public university, served in both a special forces and regular infantry units and ultimately worked for the US Postal Service. The SIZE of Uncle Sam is enormous. That makes THE IDEA of economics critical in making decisions AS PART OF THE GOVERNMENT. There is a job to do--but shortages always abound, let alone competition. As a member of the USPS I can tell you right now, creating a monopoly does not solve the problem. The problem of scarcity ALWAYS remains. Instead of buthchers, bakers and candlestick makers I prefer "love" as the centerpiece of my economic theory. Everyone says they want it, everyone agrees its an awesome good, at times like paper currency it's even considered "free"--yet no one seems to have it. Why is that? In other words "the plan" everyone is talking about with Obama, Pelosi and Reed is AMBITION and POWER (and for some strange purpose unchecked by reason or rational thought--which I call HILARIOUS!) But I thought it was supposed to be about creating a "higher good"? I mean since when is "love in the time of cholera" the goal? Doesn't that make all their "plans and designs" ultimately sad and tragic? In other words, isn't Romeo and Juliet preferable to Hitler and Stalin? And when Geithner and Emmanual are sitting down, do their feet touch the floor?

Mar 09 11:45 PM

[User 369905:]

Hey can I have what your smoking???!!!

For starters, the dollar isn't inflating it is DEFLATING....please step away from that crack pipe!


On Mar 02 11:01 AM Machiavelli999 wrote:

> Stop writing nonsensical articles Mr. Schiff and just go back to
> losing your clients millions of dollars. I am still waiting for the
> dollar to go to zero and hyper-inflation.
>
> So far, we have had the dollar at multi-year highs and deflation,
> but yea I'm sure any day now we'll have hyper-inflation and you'll
> make up for all your losses.
>
> Hey, maybe Obama and Ron Paul will get together and create a renewable
> energy source out of gold and then you'll really start to rake it
> in.

Mar 10 12:25 AM

[Wrenchmensch:]

The economic paradigms (and some indications of their inherent limitations/errors for me) are as follows:

1. Wealth is created when value is added to raw materials by labor -intellectual, physical, and efficient process capabilities i.e. production, or through trading scarce raw materials.(Market assumptions have limited lifespans.)

2. Banks were invented to amass wealth for the purpose of financing trading opportunities and wars. (The original Florentine bankers, and most subsequent banks, have come to grief when creditors are unable to repay loans.)

3. Government aid and services to individual citizens either uses wealth transferred to it through taxation, or prints money representing real and fictive wealth to be transferred to government in an indeterminate future. (Government collection of real and imagined wealth and the provision of services falter when wealth generation declines to a level below needs and expectations, and social disruption occurs - China's Dynastic Cycle phenomena).

4. Power is a concomitant of wealth. (Managing a nation's wealth requires combined mastery of economics and the exercise of power, qualities seldom found in combination in any one person.)

5. American economic policies today fall into two camps: free enterprise and socialism. These policies are increasingly viewed as mutually exclusive. (This view must be adjusted in recognition of opportunities and needs for wealth generation. (This has been a primal source of American greatness for 150 years and we must decide to sustain our free enterprise ways of life.)

Mar 12 12:19 PM