Can we restore prosperity?

John Ikerd

If the government doesn’t ensure that businesses can continue borrowing money, the economy will collapse – as it did in the 1930s. This was the argument used to coerce Congress into a hasty approval of a $700-billion government bailout of financial institutions. More recently, President Obama has promised a massive government spending program to jumpstart the economy. Perhaps the economy would have collapsed if the government hadn’t stepped in as the lender of last resort. Massive deficit spending eventually pulled the nation out of the great depression of the 1930s. Thus, government lending and spending seem to be logical economic strategies.

The government is responsible for maintaining the integrity of the banking system. We also need to repair our crumbling roads and bridges and we need to invest in a better America for the future – in clean, renewable energy and a national high-speed rail system. Now is the logical time to make such investments, even if we have to borrow the money. However, the economy of the 2000s is not the economy of the 1930s.

Government lending and spending brings about greater prosperity only when individuals and businesses have the capacity, but lack the confidence, to take the risks involved in producing things of greater economic value. Economic value in inherently individualistic, and individuals prefer to have things sooner rather than later. Consequently, people have to pay interest when they borrow and demand interest when they lend. A portion of interest rates reflects risks that borrowers won’t be able to repay their loans – the higher the risks, the higher the interest. When borrowers lose confidence in their ability to repay, they don’t borrow money. When lenders lose confidence in potential borrowers, they don’t loan money. If a large segment of the economy has been operating on borrowed money, the lack of confidence will cause an abrupt slowdown in economic activity; the economy will fall into a recession.

In such situations, the government can assume the risks that neither borrowers nor lenders are willing to take. The government can always lend and spend money because it has the ability to create new money. If a recession is due solely to a lack of confidence – if individuals and businesses have the capacity to produce more – then government lending and spending will create new jobs and new profit opportunities and thus restore confidence in the economy. New private borrowing and spending will then stimulate continuing increases in real productivity.

The critical question is whether the U.S. economy has the capacity for greater real economic productivity. Economists refer to the real economy as the money economy adjusted for inflation in prices. However, the real economic value of a thing is not determined until it is paid for; until then, its value is speculative. Investors must earn enough from their investments to pay off their loans, plus interest, and consumers must be able and willing to pay for the things they have bought on credit, plus interest. Furthermore, to the extent that an economy is supported by debt, it is a speculative economy.

Whenever debts are repaid by selling assets at prices inflated by speculation – such as stock or real estate – the economic gain is still speculative, rather than real. Whenever loans are repaid by borrowing more money, the illusion of economic growth is further compounded. Eventually, speculative values lose all connection with underlying economic reality. The speculative investor’s concern is not whether stocks or real estate is current overpriced, but whether prices will go still higher before they fall. The speculative lender’s concern is not whether borrowers can repay their loans, but whether loans can be sold to other speculative investors before borrowers default.

This deceptive ability to repay loans using speculative values creates unfounded confidence in the productive capacity of the economy. Businesses borrow and invest, consumers borrow and spend, and the illusionary speculative economy grows beyond its real economic capacity. Housing prices rise not because more people can afford new homes but because more people can get home loans. Consumer spending increases not because people are earning more money, but because more people can charge more to credit cards. Borrowing and spending keeps the money economy growing but the real value of the things produced is speculative until they are paid for, and many buyers lack the capacity to repay their loans with anything other than more loans.

Eventually, the speculative bubble bursts, the speculative illusion is revealed, and the economy falls back toward its real economic capacity, resulting in huge losses speculative investments, widespread bankruptcies, and massive unemployment. If panic sets in, economic productivity may even fall below the economy’s real productive capacity. Massive government lending and spending may prevent such an economic collapse by stemming unwarranted losses of investor and consumer confidence. Thus, government intervention is certainly justified in such cases.

However, government lending and spending do not expand the real productive capacity of an economy. During the Great Depression, the nation had the capacity to produce; it only lacked the confidence. Unfortunately, no one knows how much of real productivity capacity is left in the U.S. economy.

If government intervention simply renews speculation, it will do more harm than good. Given time, government spending for such things as infrastructure, research and development, and education can enhance the real productive capacity of an economy and stimulate real economic growth. However, the real U.S. economy of the future must be built upon a badly eroded foundation of the real economy of today, not the current speculative economic illusion. Unfortunately, the current real economy – its ability to produce things of real economic value – may be a reality that many Americans are not yet ready to accept.