Thursday, March 6, 2008

Excerpts about Money versus Wealth

There was a discussion on the economics list at work about what somebody had described as an "Austrian purge." This was discussing evidence that the Fed was in fact deflating. This led to a back and forth discussion about how capital was and is allocated. I responded with the following, which Vijay thought was worthy of being a blog post:

It's fundamental when trying to figure these issues out to understand what capital really is. It gets to the distinction between money and wealth. Wealth is the stuff that we want (e.g. healthcare, food, housing, ipods, education for our kids). Money is just an abstraction humans invent in order to facilitate the division of labor. For example, I want to buy groceries tonight from a supermarket and the guy in the supermarket doesn't need any of the software code I write. Money is the intermediate means of exchange that allows this to happen. My employer gives me money in exchange for my code and I give the the supermarket money in exchange for their groceries. It's easy to confuse money and wealth on a microeconomic level because for the average person, they are the same thing. But at a macroeconomic level, money does not equal wealth. If it did, the Federal Reserve could make us all rich by creating billions of dollars out of thin air.

So when we talk about the misallocaiton of capital, it's important to talk about what was misallocated. At the macro level, the reality of what was misallocated can be lost in the abstraction of money. Capital is the means of production that provides wealth. Examples of capital are hard assets like farm land, factories, and machinery. But capital can also be intellectual capital like a medical education or a software engineering degree. It can also be collective capital we build up in a society like an effective legal system or a smoothly operating financial system. A house can be capital because it's hard to imagine anybody being productive if they had no place to live. When talking about capital misallocation, I think it's important to also talk in these terms because things can get lost in the abstraction of money.

So what got misallocated? We probably built around one million more homes than we actually needed. So all that labor that was used for building homes could have been used for more production of things we actually needed. The rapid rise of real estate resulted in millions of people deciding to take employment in the real estate market. So we trained millions of real estate brokers, mortgage brokers, and construction workers to do work that we didn't need them to do. They could have been learning other skills like becoming doctors, nurses, and healthcare technicians of which we actually have a shortage. Then there was the wealth effect of rising housing prices. People thought that their home would always rise in price and so there was no need for savings. So instead, they borrowed against their homes and spent money on consumer items that have no lasting value such as eating out, consumer electronic devices, expensive cars, extra vacations, etc., The money going into these areas resulted in businesses misallocating capital and building too many restaurants, factories, and hotels. It also resulted in a huge savings imbalance. We have huge credit deficits and other parts of the world have huge credit surpluses. Savings is just deferred consumption. That means that we are going to be working really hard in the future to reward the rest of the world for all the hard work they did in the present and past. It doesn't bode well for a country with demographics of an aging population that the United States has.

There is a place where the intersection of money and wealth become important. We have a fiat currency and a fractional reserve banking system. Credit can be created by the government and by the private sector. Our system, for the most part, treats credit and money as the same thing. It turns out that an increase in the supply of money and credit (i.e. inflation) causes misallocation of capital. This is the boom. Eventually, things revert to the mean and you get the bust. Trying to reinflate the bubble as some people would like the Fed to do is no more effective than giving a heroine junky more drugs to stop his withdrawal symptoms. It can feel good for the time being, but it just results in an even bigger bust later on.

Somebody responded and suggested that there was economic value due to the creation of all these consumer products. First, it provided a "safety valve" for all the extra money being created to go. Second, it resulted in efficiency gains for creating those items. And finally, somebody made profits and that somebody, maybe Warren Buffet, will figure out how to create economic value with those profits in the future. I responded to this by saying

The idea of a "safety value on the flow of money" gets at the heart on the confusion between money and wealth. You have to look at the impact on real economic activity. If the economy was distorted causing people to buy too many consumer electronics, it means that producers were shifting resources into figuring out how to produce more of these devices. Those are resources that could have been used for something else. If the resources were being deployed as part of a real economic demand, that is a functional free market. If the resources are misallocated because businesses received bad signals due to monetary inflation, that is not a good use of capital. Yes, Warren Buffet, or whoever profited, can make better decisions in the next round. But the wealth that was misallocated in the first previous round is forever lost. We needed more capital to help us produce X and instead we now have too much capital to help us produce Y. The problem now is the dislocation. All those people that took jobs or trained for jobs or invested in careers have to get laid off and retrain. That is a very painful process. This is why steady real growth is preferable to booms and busts.

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